For U.S. Expats: Tax Loss Harvesting―A Strategy for Volatile Markets
01 Nov 2011 12:41 am
This article is for general information purposes only and is not intended as specific tax advice. Please consult your tax advisor for advice relevant to your situation.
With all the ups and downs in the markets this year, it's likely you're sitting on a loss somewhere in your portfolio, especially if you've been following a disciplined strategy of regularly adding to your investments for retirement. Suffering short-term "losses" in the pursuit of achieving longer-term gains is never fun, but if you are a U.S. expat, there is a way you can use these short-term "losses" to your advantage. By realizing your losses and offsetting them against realized investment gains and other income, you can reduce your current year U.S. tax burden, defer tax, and even boost your portfolio returns through a process called tax-loss harvesting (TLH).
This technique can be particularly useful for American expats who are subject to U.S. tax on worldwide income and investment earnings and who tend to be in the upper tax brackets. While the rules outlined in this article are geared towards expat investors subject to the U.S. tax code, the same general technique may also be employed by expats of other nationalities who are able to offset gains with investment losses to lower their tax burden.
How Does Tax-Loss Harvesting Work?
Suppose you've been buying Vanguard's Emerging Market ETF (VWO) as part of your long-term portfolio strategy. Due to recent concerns surrounding the problems in Europe, the value of VWO has dropped and you are now sitting on a USD 10,000 unrealized short-term loss. Also, assume you are in the 35% tax bracket and you have USD 5,000 in short-term capital gains for the year.
As it stands now, your tax liability on your short- term capital gains is USD 1,750 or 35% of USD 5,000. Having read about TLH somewhere (and checking with your tax advisor), you decide to give it a try. So, you sell VWO and realize the USD 10,000 loss. At the same time you buy iShares MSCI Emerging Markets Index (EEM)―a similar but not "substantially identical" exchange traded fund―with the proceeds received from the sale of VWO. After all, you want to maintain exposure to emerging markets as part of your long-term diversified portfolio strategy and you don't want to miss out on any rallies.
At this point, you've sold VWO realizing a USD 10,000 loss and bought EEM with the proceeds, essentially maintaining your portfolio allocation as it was prior to the sale. You can now use the USD 10,000 loss to offset the USD 5,000 short-term gains, thereby saving U.S. tax of USD 1,750. You can use another USD 3,000 of the losses (each year) to offset ordinary income, saving another USD 1,050. Finally, you can carry the remaining USD 2,000 loss forward to use next year against capital gains or ordinary income.
Your tax liability for the year has gone from USD 1,750 to a net tax savings of USD 2,800. That's not counting the benefit of the USD 2,000 carried forward. Meanwhile, your investment portfolio remains intact with the same diversified exposure it had before the sale of VWO. All you've done is "harvest" the tax loss to reduce your current-year tax burden.
What Are the Benefits?
Tax-loss harvesting offers a number of benefits:
- Realized capital losses can be used to offset realized capital gains. This can lower current year taxes.1
- Any remaining realized losses after offsetting realized gains can be used to offset ordinary income up to USD 3,000 per year.
- Unused losses from previous years can be carried forward to offset future gains and/or offset up to USD 3,000 of ordinary income per year until all losses are used up.
1This is actually a tax-deferral rather than a savings. When you re-buy the same or an alternate fund you are effectively lowering your cost basis. Future gains will eventually be taxed with the effect of recapturing the taxes offset by the realized loss. Still, the tax deferral is valuable due to the time value of money and is effectively an interest-free loan―probably the only free lunch you'll get from the IRS.
Excess Portfolio Returns from Tax-Loss Harvesting
In a study, "Loss Harvesting: What's It Worth to The Taxable Investor?," by First Quadrant, L.P. that appeared in the Journal of Wealth Management, the authors tried to quantify how much TLH was worth to the taxable investor. They found that TLH could add up to 0.60% per year in excess returns above benchmark index fund returns. This required no particular investment skill or additional risk, just active management of portfolio taxes.
This may not sound like much, but consider that the financial service industry is dominated by active managers all trying to outperform their relevant benchmark index on a pre-tax basis. They typically charge large fees and take significant risk for the uncertain quest of outperforming their passive benchmark. Few succeed over any significant time periods.
As the authors point out, it takes 2%–3% pre-tax alpha (additional returns) for an active fund to match the after-tax returns of a plain vanilla index fund. In the fund management industry, that much outperformance is huge and almost impossible to replicate over long periods.
If active managers succeed in outperforming on a pre-tax basis, the outperformance doesn't go to the investor, it goes to the IRS. In other words, the investor ends up paying large fees and taking additional risk just to have the excess returns go to the government.
In contrast, tax loss harvesting and other portfolio tax management techniques require no particular investment skill or luck, entail no additional risk, and the benefits accrue to the investor, not the IRS.
Some Rules You Need to Know
As with anything dealing with the IRS, there are a number of rules and caveats. The most important are:
- Wash Sale Rule: The IRS disallows the recognition of a loss on the sale of a security if the same or "substantially identical" security is bought within 30 days before or after the sale. The period subject to the wash sale rule extends 61 days, 30 days on either side of the sale including the sale date.
- Substantially Identical: Substantially identical means the same stock, fund or ETF, different classes of the same security, and options/ contracts on the same security. Funds or ETFs with the same underlying exposure and percentage holdings are likely to be considered substantially identical.
Selling Coke and buying Pepsi is fine. Selling Vanguard's S&P 500 fund and buying Vanguard's Large cap fund is probably fine. Selling Vanguard's S&P 500 fund and buying Fidelity's S&P 500 Fund is probably pushing it. Always check with your tax advisor.
Also, if you buy the same or substantially identical security in your IRA, spouse's account, or the account of a company you control within the 61-day window, you also violate the wash sale rule.
Some Other Considerations
If you plan to make TLH part of your portfolio strategy, here are a few other things to consider:
- TLH is obviously intended for your taxable accounts. There is no benefit to be obtained from this technique in IRAs or 401(k)s.
- Be careful trading in your IRAs and 401(k)s so as not to trigger the wash sale rule.
- If you automatically reinvest dividends and other fund distributions, you may accidently trigger the wash sale rule. If you plan to tax-loss harvest, it's better not to have distributions reinvested.
- Capital losses cannot be used to offset short term capital gains distributions
- If you have both short- and long-term gains and losses, first match each type of loss to offset the same type of current gain: long-term losses against long-term gains, short-term losses against short-term gains. After that, you can use any leftover losses first to offset current long-term gains and then to offset short-term gains.
- Look for TLH opportunities throughout the year rather than only at year-end.
- Track your cost basis per lot rather than using average cost basis.
- Put volatile asset classes in your taxable account.
- TLH can be an effective technique to whittle away exposure to low-basis, highly concentrated stock positions.
- Be aware of trading costs, redemption fees, and frequent trading restrictions that accompany some mutual funds.
Losses in your portfolio are never fun whether they are realized or not. Still, there's no point letting them go to waste. With tax loss harvesting, you can lower current-year tax, defer taxes, and even improve your portfolio's long-run return.
The rules can be complicated and some effort is required to keep track of the accounting, so this is probably an area where you will want to work with your tax or financial advisor.
Creveling & Creveling is a private wealth advisory firm specializing in helping expatriates living in Thailand and throughout Southeast Asia build and preserve their wealth. Through a unique, integrated consulting approach, Creveling & Creveling is dedicated to helping clients cut through the financial intricacies of expat life, make better decisions with their money, and take the steps necessary to provide a more secure future. For more information visit http://crevelingandcreveling.com/.
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