As the end of year approaches, family office investors assess the performance of their portfolios and consider how to position for the coming year. As part of this exercise, family offices routinely look for ways to optimize their after-tax returns through tax loss harvesting.
Below are some tips from the pros.
Look for opportunity. Investors can often overlook capturing tax losses as they focus on portfolio construction and evaluating manager performance. Family offices know that the only returns that matter are those that they keep, after taxes. Although family offices do this routinely at the end of the year, investors should be in the habit of evaluating whether to sell investments to recognize a tax loss whenever the market is volatile. This does not necessarily eliminate tax liability, but rather functions as an interest free “loan” that defers capital gains taxes into the future. Although tax loss harvesting doesn’t eliminate your losses, if done strategically it can very much soften the blow as those losses can be used to offset gains that you would otherwise have to pay taxes on.
Understand your specific scenario. The value of tax loss harvesting depends upon the investor’s individual situation, including their income level and the amount of short-term and long-term capital gains in their portfolios. Short-term and long-term capital gains are taxed at different levels. Investors incur a short-term capital gain on investments that they sell at a profit after less than a year. These gains are taxed at the marginal rate paid on ordinary income, which federally can be as high as 43.4 percent for investors in the highest income tax bracket of 39.6 percent, and are also subject to the net investment income tax of 3.8 percent. Long-term capital gains, which are triggered on investments held for more than a year, can be federally as high as 23.8 percent, composed of a 20 percent capital gains tax and the 3.8 percent net investment income surtax.
Target short-term losses first. Offsetting short-term losses with gains is most valuable, so when family offices incur large short-term gains, they search for investments in their portfolios with short-term losses to offset these gains — especially if they have lost conviction over them or they no longer fit in their overall strategy. Investors can also offset short-term gains with long-term capital losses once they have “used” up all of their short-term losses. For example, imagine an investor invests $100,000 in an S&P 500 index fund (ticker: IVV) on January 1, 2016. Unfortunately, given how volatile the markets were, that $100,000 was only worth $90,000 in mid-February. However, imagine that through other investment activities the investor has $10,000 of short-term gains — which would be taxed at the ordinary income level — so she decides to sell IVV, harvest the loss to offset this gain, and then with the $90,000 buy a Russell 1000 ETF which provides very similar investment exposure. While she won’t be doing her 2016 taxes for a little bit, she has just saved close to $4,500 in taxes. Furthermore, imagine that she sells her Russell 1000 ETF two years from now and it is worth $110,000. She now has $20,000 of long-term capital gains, which would result in $4,800 in taxes.
Keep the flowers; pull the weeds. Family offices do not harvest tax losses if it will undermine a diversified investment portfolio. Investors should target depreciated investments that no longer fit their overall strategy, investments that they believe have poor prospects for future growth, or investments that they believe can be replaced with similar investments that do not create “wash sales.” The “wash sale” rule states that if an investor sells a depreciated security and buys a substantially identical security within 30 days, the capital loss created in the sale is not deductible. This applies across an investor’s accounts — one cannot sell a given security in one account and buy back the same security (or something substantially identical) in another account — including your IRAs or a spouse’s account.While year-end is a great time to think about tax loss harvesting — so you don’t miss the benefits for this year’s tax returns — investors should also consider this strategy any time a portfolio shift is being discussed. It’s one of the smartest ways that investors can turn a win-lose in their portfolio into a win-win.