Here's what to do if you have a loss on an investment

After racking up banner gains in 2021, markets are on a downward trajectory. So chances are you’ve lost some good money … at least on paper

Sure, you may make it back once stocks and other securities do an about-face. But for now, one way to benefit from the current market is to harvest some losses in the taxable portion of your portfolio — that is, in those investments you hold outside of tax-advantaged vehicles like 401(k)s and IRAs.

So-called “tax loss harvesting” can benefit you in a few ways: It can lower your investment and income taxes not just this year, but in future years, depending on how big of a loss you book.

It also can provide you a welcome opportunity to rebalance your portfolio.

“It doesn’t cost anything and may save you some money too,” said North Carolina-based certified financial planner Dan Tobias.

But doing it right isn’t as easy as it sounds, so you may benefit from working with a financial adviser who has experience with tax loss harvesting.

How it works

When you sell a stock, bond, mutual fund, ETF or even a cryptocurrency for less than you paid for it, you book a capital loss.

That loss can directly offset the tax on any realized capital gains you have plus up to $3,000 in ordinary income. If you book losses this year — and don’t take any gains — you can use the losses to take a deduction on up to $3,000 of your ordinary income and then carry forward any remaining losses for use in future years. There is no time limit on when you can apply them.

For example, say you bought something at $30,000 and sell it this year at $25,000. You have booked a $5,000 capital loss.

If you also sell an appreciated asset this year, your loss will directly offset up to $5,000 in capital gains. And if you book less than $5,000 in gains, you can offset all your gains and use the rest to offset your ordinary income. If you don’t have any gains, you can use $3,000 of your losses as a $3,000 deduction against your ordinary income and then carry forward the remaining $2,000 in losses for use in the future.

For many investors using $3,000 in losses to offset regular income taxes can be more financially beneficial than offsetting gains, said Indiana-based CFP Russ Ford, because their income tax rates are higher than their long-term capital gains rate, which is 15% for most investors. And for some it’s even 0% — specifically, people whose taxable income in 2022 is below $42,000 ($84,000 if married filing jointly). If you have a short-term gain, however — which applies to an investment you hold less than a year — your capital gains rate will be the same as your ordinary income tax rate.

The best way to harvest tax losses

Ideally when you harvest a tax loss you will immediately reinvest the money from the sale into an asset that is similar but not “substantially identical” to maintain the same exposure to a sector or asset class.

“You never know what you’re going to miss out on,” said Michigan-based certified public accountant and CFP Ashlee deSteiger.

But you have to be careful when buying something in tandem with your tax loss sale to avoid violating what’s called the wash-sale rule. If you run afoul of it, the IRS will disallow the benefits of your tax loss.

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The wash-sale rule prohibits you from buying the same stock or security 30 days before or after your loss-sale date, said Virginia-based CPA and CFP Mike Powers.

Also important to note: The rule applies across all your accounts, not just the taxable portion of your portfolio. In other words, if you want to sell your IBM stock at a loss in your brokerage account, you can’t buy IBM stock through your 401(k) or IRA within that 60-day period.

“The rule applies to the tax ID of the person, not the account,” deSteiger said.

But the wash-sale rule does not (yet) apply to tax losses on cryptocurrencies, which the IRS classifies as property. That may soon change, however, as lawmakers and the SEC are seeking to better regulate crypto trading. The Build Back Better bill, for example, included a provision that would subject crypto to the wash-sale rule.

The opportunity to rebalance

Selling investments to take a capital loss also gives you a tax-free opportunity to rebalance your portfolio if you also sell holdings that have capital gains — perhaps because those gains have thrown off your asset allocation or the holding no longer serves your investing needs.

“Harvesting losses can help you rebalance other positions that may have large unrealized gains, such as company stock or a mutual fund with a high expense ratio you’ve been looking to sell,” Powers said.

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