Market Sell Off: Consider Tax-Loss Harvesting

Avoiding the urge to sell stocks during a market downturn is generally a good strategy, as downturns tend to be short-lived. The recovery can happen quickly and often when the outlook appears the worst. However, there is one tax strategy that might be useful during times like these, tax-loss harvesting.

Tax-Loss Harvesting

Tax-loss harvesting is the strategy of selling investments that are trading below your cost basis. This loss is then "harvested" and available to be used to offset future capital gains.

There is no limit to the amount of losses you can harvest. And, there is no time period in which those losses must be used. You have these losses available to offset future capital gains until they are used.

Note: This only works in taxable accounts, so, unfortunately, no benefit for tax-loss harvesting in retirement accounts.

Beware the Wash-Sale Rule

The rules of tax-loss harvesting are straightforward but with some items of note. If you want to avoid trying to time the market, you will want to sell any stocks or funds with losses and immediately reinvest those proceeds.

However, before reinvesting proceeds, it is important to understand the IRS “Wash-Sale Rule”. This rule prohibits selling an investment for a loss and replacing it with the same or a "substantially identical" investment 30 days before or after the sale.

To avoid triggering the wash-sale rule, you could sell the investment and repurchase the very same investment 31 days later. However, this will leave you out of the market for 30 days, which could feel like an eternity during volatile times.

You can also sell out of one investment and buy another investment immediately as long as it is not considered "substantially identical." Before doing this, make sure you do not accidentally trigger the wash-sale rule. Below are a couple of common pitfalls you need to avoid:

• You cannot sell an investment for a loss in a taxable account and buy it in one of your retirement accounts within 30 days before or after.
  
  
• In addition, you cannot sell an investment for a loss in a taxable account in your name and buy it in a spouse's account within 30 days before or after.
  
  

What Happens if You Trigger the Wash-Sale Rule?

If you trigger the wash-sale rule, you will not be able to use the loss on your tax return. Instead, the loss amount is added to the cost basis of the new investment you purchased that triggered the rule. So eventually, you will get to use the loss on your taxes, but only after you sell the new investment down the road.

Conclusion

Tax-loss harvesting can be one of the few benefits of a market selloff. However, you want to make sure you can use that benefit on your taxes, so knowing the wash-sale rule is important. Also, note that the IRS has never clearly defined "substantially identical investments", so take note if you look to swap investments within the 30-day window.

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