I've been working on a method to 'safely' Tax Loss Harvest (TLH) which brings together many recent thoughts. However, in doing so, I realized that perhaps TLH is another one of those things being overplayed, again by the Robo Advisor crowd. I've not yet conducted deep research on this, so would certainly be glad to be proven wrong here.
I suppose I should start with 'The What?' before The How and The When. Tax Loss Harvesting means selling losing investments in order to register the Loss. The losses you register can be accumulated and carried forward, they are used to cancel out capital gains, or to reduce your ordinary income by $3000 per year. The order is Cap Gains must be canceled out first, then any overage can go onto OI, then any balance carried forward. A very powerful tool.
The Wash Sale Rule (section 1091 IRS Code) was introduced to stop people selling a losing stock on Dec 31st, capturing the loss, and repurchasing on Jan 1st. They introduced a rule where if you purchase the replacement stock 30 days before or after you will trigger a wash sale. Wash sales disallow the loss, and instead the basis is recalculated. The verbiage is repurchase of the same or substantially identical security shortly before or after.
The window of opportunity here is the phrase bolded - substantially identical. The 'same' is impossible to argue, if you sell Ford and then buy it again it is always going to be Ford. But when you buy Funds, what makes them identical? This is one of those grey areas where opportunity, and risk abound.
The How
The method I have been considering to address this started with 'pairing' funds. I am looking at correlation here. If we can find funds that are not substantially identical, yet move with correlation we have an opportunity to maintain portfolio balance while harvesting losses. I am still compiling the best pairings, but to give an example of how two substantially different funds perform, simply plug total stock market (VTI) and S&P 500 (VOO) into yahoo finance.
This might be considered a clumsy pairing, or by the same token a safe one, as no financier would argue that these two funds are identical. As the nuances become narrower between the funds, so does the variance. The key is to find the closest correlation while maintaining quantifiable differences. A commonly discussed solution is to ensure that not only different firms are offering the fund, but more importantly that the funds are tracking different underlying benchmarks. Using Total Stock vs 500 is one such benchmark, but more subtle ones can occur using Russell Indices and others.
The When
This is the overplayed part. You can only Capital Loss Harvest when your investment is a loss. Sound simple? Well, more specifically, if your investment as appreciated and subsequently has depreciated, that doesn't necessarily create a harvest opportunity. This year (final week of July) we had a big drop in the S&P 500, 2.7% in 5 days. Despite this, only some people would have a capital loss harvest opportunity from this.
If you had invested $10,000 in VOO on Jan 1st 2014 at the price of $167.73 it would have grown to a high of 182.15 per share in July, before dropping to $176.08. Despite this drop, you're investment is still up, as no realization event has occurred, and there is no Capital Loss Harvesting available to you.
Conversely, if you had the misfortune to enter the market during July, and bought in at the high of $182.15 you would have the opportunity to harvest the loss when it had dropped down to $176.08. The window would be narrow, and within a month the asset would have regained its footing. An automated harvest here would offer a lot of value, if a person would exit VOO, lock in a loss of up to $333 in this transaction. The amount harvested is, of course, impossible to predict since it would require market timing and a crystal ball, but it would be possible to capture a maximum of $333 here.
Moving the balance of $9667 into VTI for 1 month would have created a gain of 4.49% rather than 4.20% from VOO, as the total stock market performed better than the S&P500. After a month has passed, the VTI could be sold, and the portfolio could revert to VOO...
Herein lies the problem of clumsy correlations. If the portfolio is put too far out of alignment by the replacement investment (VTI in this case) then the act of rebalancing it by selling out of VTI creates a capital gain event that nullifies the Capital Loss harvest. The key is finding the 'pairing' where you would be happy with either, and not need to rely upon it purely for a 30 day stop gap.
Final Thoughts
Pairing funds properly is the key to long term capital loss harvesting success, Any rebalancing that entails selling a winner (within a taxable account) destroys any effort to harvest losers. And as you can see, even with capital loss harvesting, timing is required both on entry to the trade, and when to lock in the loss, and as such can be overrated in a bull market.
I suppose I should start with 'The What?' before The How and The When. Tax Loss Harvesting means selling losing investments in order to register the Loss. The losses you register can be accumulated and carried forward, they are used to cancel out capital gains, or to reduce your ordinary income by $3000 per year. The order is Cap Gains must be canceled out first, then any overage can go onto OI, then any balance carried forward. A very powerful tool.
The Wash Sale Rule (section 1091 IRS Code) was introduced to stop people selling a losing stock on Dec 31st, capturing the loss, and repurchasing on Jan 1st. They introduced a rule where if you purchase the replacement stock 30 days before or after you will trigger a wash sale. Wash sales disallow the loss, and instead the basis is recalculated. The verbiage is repurchase of the same or substantially identical security shortly before or after.
The window of opportunity here is the phrase bolded - substantially identical. The 'same' is impossible to argue, if you sell Ford and then buy it again it is always going to be Ford. But when you buy Funds, what makes them identical? This is one of those grey areas where opportunity, and risk abound.
The How
The method I have been considering to address this started with 'pairing' funds. I am looking at correlation here. If we can find funds that are not substantially identical, yet move with correlation we have an opportunity to maintain portfolio balance while harvesting losses. I am still compiling the best pairings, but to give an example of how two substantially different funds perform, simply plug total stock market (VTI) and S&P 500 (VOO) into yahoo finance.
This might be considered a clumsy pairing, or by the same token a safe one, as no financier would argue that these two funds are identical. As the nuances become narrower between the funds, so does the variance. The key is to find the closest correlation while maintaining quantifiable differences. A commonly discussed solution is to ensure that not only different firms are offering the fund, but more importantly that the funds are tracking different underlying benchmarks. Using Total Stock vs 500 is one such benchmark, but more subtle ones can occur using Russell Indices and others.
The When
This is the overplayed part. You can only Capital Loss Harvest when your investment is a loss. Sound simple? Well, more specifically, if your investment as appreciated and subsequently has depreciated, that doesn't necessarily create a harvest opportunity. This year (final week of July) we had a big drop in the S&P 500, 2.7% in 5 days. Despite this, only some people would have a capital loss harvest opportunity from this.
If you had invested $10,000 in VOO on Jan 1st 2014 at the price of $167.73 it would have grown to a high of 182.15 per share in July, before dropping to $176.08. Despite this drop, you're investment is still up, as no realization event has occurred, and there is no Capital Loss Harvesting available to you.
Conversely, if you had the misfortune to enter the market during July, and bought in at the high of $182.15 you would have the opportunity to harvest the loss when it had dropped down to $176.08. The window would be narrow, and within a month the asset would have regained its footing. An automated harvest here would offer a lot of value, if a person would exit VOO, lock in a loss of up to $333 in this transaction. The amount harvested is, of course, impossible to predict since it would require market timing and a crystal ball, but it would be possible to capture a maximum of $333 here.
Moving the balance of $9667 into VTI for 1 month would have created a gain of 4.49% rather than 4.20% from VOO, as the total stock market performed better than the S&P500. After a month has passed, the VTI could be sold, and the portfolio could revert to VOO...
Herein lies the problem of clumsy correlations. If the portfolio is put too far out of alignment by the replacement investment (VTI in this case) then the act of rebalancing it by selling out of VTI creates a capital gain event that nullifies the Capital Loss harvest. The key is finding the 'pairing' where you would be happy with either, and not need to rely upon it purely for a 30 day stop gap.
Final Thoughts
Pairing funds properly is the key to long term capital loss harvesting success, Any rebalancing that entails selling a winner (within a taxable account) destroys any effort to harvest losers. And as you can see, even with capital loss harvesting, timing is required both on entry to the trade, and when to lock in the loss, and as such can be overrated in a bull market.
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