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Evaluating The Tax Deferral And Tax Bracket Arbitrage Benefits Of TaxLoss Harvesting

PostedbyMichaelKitcesonWednesday,December3rd,7:01am,2014inTaxes

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Taxlossharvestingisapopulartaxplanningstrategy,especiallyastheendoftheyearapproaches

andinvestorsconsidertheirpotentialcapitalgainsexposure.Yetformanyinvestors,thebenefitof

taxlossharvestingisoverestimated,asharvestingalossgeneratescurrenttaxsavings,butalso

reducesthecostbasisoftheinvestment,triggeringapotentialgaininthefuturethatmayoffset

mostorallofthelossharvestingbenefit!

Nonetheless,evenifaharvestedlosscreatesafuturegain,thereisstillanopportunityfortax

deferralinthemeantime,whichcancreateamodestbutnontrivialeconomicbenefitfortaxloss

harvesting.Thebenefitsarefurtheramplifiedsometimesgreatlysoifthereisapotentialthat

gainsinthefuturewillbetaxedatalowerratethanlossesharvestedtoday,withthecaveatthat

ifbracketsgotheotherdirection,taxlossharvestingnotonlylosesitspositivevaluebutcan

actuallybewealthdestructive!

Totheextentthattaxbracketschangesareanticipatedfavorable,thoughoratleast,thatrates

willholdsteadysomebenefittotaxlossharvestingremains,andcanbemaximizedwith

portfoliosthatholdawiderangeofdiversifiedpositions(creatingmorelossharvesting

opportunities),haveongoingcontributions(againcreatingmorelossharvestingopportunities),and

arecheckedfrequentlyforlossestoharvest(asonlytryingtoharvestlossesinDecembercanmiss

outonevengreaterintrayearlossharvestingopportunities!).Andforthosewhoarenotatrisk

foradversetaxbracketchanges,thetaxlossharvestingopportunityisespeciallyappealingin

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foradversetaxbracketchanges,thetaxlossharvestingopportunityisespeciallyappealingin

todaysenvironment,withtransactioncosts(includingtradingfeesandbid/askspreads)aslowas

they'veeverbeen,andmoreopportunitiesthanevertoowninvestmentalternativesthat

minimizetrackingerrorwhilenavigatingthewashsalerules!

The History Of Tax Loss Harvesting

SincetheFederalgovernmenttaxesanincreaseinthevalueofinvestmentpropertyasacapital

gain,itsonlyfairthatinvestorsbepermittedtoreducetheirincomefortaxpurposesbythe

amountofanylossesthataregenerated.Infact,beyondallowingcapitallossestooffsetcapital

gains,thetaxcodealsoallowsindividualstomanagetheburdenoftaxationbyallowinganygains

oninvestmentpropertytoremaintaxdeferreduntiltheinvestmentisactuallysold(whichcauses

thegainstoberecognizedfortaxpurposes).

Yetthefactthatcapitallossescanbedeductedfortaxpurposestogeneratecurrenttaxsavings,

whilecapitalgainscanbedeferredbysimplynotsellingtheinvestmenttorecognizethegain,

createsthepotentialthatinvestorswilltakeadvantageofthetaxcodebytryingtoproactively

recognizelossesnowfortaxsavingsbutpushgainsintothefuture.Andinthefirstdecadeofthe

taxcode,thatsexactlywhathappenedinfact,someinvestorsweresoaggressiveaboutit,they

wouldsimplysellinvestmentsthathadlossesandpurchasethembackagainimmediately,

harvestingthelossfortaxpurposestogeneratecurrenttaxsavings,butwithouteven

substantivelychangingtheiroriginalinvestment!

Tolimitthiskindofabuse,CongressenactedIRCSection1091asapartoftheRevenueActof

1921,whichdeclaredthatiftheinvestorsoldaninvestmentforataxlossbutpurchaseda

substantiallyidenticalsecuritythatthelosswouldbedisallowedfortaxpurposes.Increatingthese

washsalerules(whichhavebeeniterateduponoverthedecadestocrackdownonfurther

abuses),though,Congressalsoindirectlyblessedandenshrinedintolawthestrategyoftaxloss

harvestingtogeneratecurrenttaxsavingsaslongastherequisite30dayruleisnavigated.

Tax Loss Harvesting And The Problem With Annual Tax Alpha

Sincetheessenceoftaxlossharvestingistocreateadeductiblelossfortaxpurposestogenerate

currenttaxsavings,theeasiestwaytomeasurethebenefitsofthestrategyissimplytomeasure

howmuchintaxesisactuallysavedrelativetotheinvestment.

Forinstance,ifaninvestmentwasoriginallypurchasedfor$20,000butisnowdownto$14,000

(abig30%decline),thenharvestingthelossgeneratesa$6,000capitalloss,whichinturn

(assumingtherearecapitalgainstooffsetitagainst)willproducea$900taxsavingsata15%

longtermcapitalgainstaxrate.Relativetoaninvestmentvalueof$14,000,thismeans

harvestingthecapitallossgeneratedawhoppingtaxalphaof$900/$14,000=6.4%.

However,therealityisthatharvestingthelossdidnotreallyincreasetheinvestorswealthby

$900oftaxsavingsinthelongrun.Thereasonisthatwhiletheharvestedlossdidgenerate$900

ofcurrenttaxsavings,theactofharvestingthelossalsoreducesthecostbasisoftheinvestment.

Bysellingtheinvestmentat$14,000toharvestthecapitallossandthenreinvestingthe$14,000

http://www.investopedia.com/terms/w/washsalerule.asphttp://www.jstor.org/stable/1801769?seq=1http://www.law.cornell.edu/uscode/text/26/1091



Bysellingtheinvestmentat$14,000toharvestthecapitallossandthenreinvestingthe$14,000

ofproceeds,thenewcostbasisgoingforwardwillbe$14,000.Whichmeansif/whenthe

investmenteventuallyrecoversbacktoitsoriginal$20,000,theinvestorwillfaceafuture

recoverygainof$6,000,andanegativetaxalphaintheyearofliquidation!Infact,ifthat

capitalgaininturnresultsina$900taxbill(assumingthesame15%longtermcapitalgainstax

rate),thenetvalueofthetransactionisactuallytheexactsameaswouldhaveoccurredifloss

wasneverharvestedinthefirstplace!

Thecaveat,though,isthatthetrueeconomicvalueoftaxlossharvestingisnotquiteaperfect

zero,eventhoughthefuturegaincreatedbyharvestingthelosswilloffsetthetaxsavings

generatedbytheloss.Thereasonwhythereisstillabenefittotaxlossharvestingisthattheloss

iscreatednowproducingadditionaldollarstoinvestwhiletherecoverygainwillnotcreatea

taxableeventuntilsomepointinthefuture.Inthemeantime,theinvestorhastheopportunityto

use,invest,andgrowthat$900.Inotherwords,whiletaxlossharvestingdoesntnecessarily

produceanynettaxsavings,itistheequivalentofgettinganinterestfreeloanfromtheFederal

governmenttousefora(potentiallylong)periodoftaxdeferral.

Measuring The Economic Value Of Tax Deferral

Sogiventhattaxlossharvestingisreallyabouttaxdeferral,andnotoutrighttaxsavings,howcan

wemeasuretheeconomicvalueoftaxdeferral?

Atthemostbasiclevel,thebenefitoftaxdeferralissimplythevalueofthegrowththatcanbe

generatedonthattemporaryloanfromtheFederalgovernment,untilitmustbereturned.For

instance,continuingtheearlierexample,ifthe$900oftaxsavingscanbeinvestedforanaverage

returnof8%,thenthetruevalueofthetaxdeferralis$72worthofgrowth.Ona$14,000

investment,thisequatestoatruetaxbenefitof0.51%after1year(andifwerecognizethatthe

$72ofgrowthwillitselfbesubjecttoa15%taxrate,thenetbenefitis0.44%).



Ofcourse,thecaveattothisexampleisthataslongastheinvestmentcontinuestobeheld,the

economicvalueoftaxdeferralcontinuestogrow,andtocompound.Inotherwords,itsnotjust

thatthevalueofharvestingthelossis$72worthofgrowth,butthatits$72ofgrowth,

compoundingovertime,untilitisultimatelysold!Accordingly,thechartbelowshowsthe(net

aftertax)amountofadditionaldollarscreatedovertimebyharvestingthe$6,000loss.

Thus,thebenefitoftaxlossharvestingovertimeiseffectivelyatailwindofadditionaleconomic

growthgeneratedasaresultofinvestingthetaxsavingsfromtheoriginalharvestingtransaction.

Accordingly,wecancalculatethetrueeconomicbenefitoftaxlossharvestingovertimeby

comparingtheamountofwealthcreatedbyharvestingtheloss,comparingittothewealththat

wouldhaveexistedwithoutharvestingtheloss,andcomparingtheinternalrateofreturnbetween

thetwothedifferencerepresentstheexcessreturnequivalentcreatedbythetaxloss

harvestingtransaction.Notably,inthelongrun,theexcesswealthindollarscontinuesto



harvestingtransaction.Notably,inthelongrun,theexcesswealthindollarscontinuesto

compoundupwards,buttheexcessreturnrelativetothereturnsthemselvesbeginstoflattenand

providediminishingreturnsoncetheinvestmentrecoversaboveitsoriginalcostbasis.

Astheresultsshow,whilethebenefitoftaxlossharvestingispositive,itisnothugeandisfar

smallerthantaxalpha(calculatedbasedonsingleyeartaxsavingsalone)implieswitha30%

declinefollowedby7%growth,theeconomicvalueoftaxlossharvestingrisesashighasalmost

0.30%/yearofadditionalannualizedreturnequivalentat15%taxrates(or0.42%at23.8%top

capitalgainsrates),fallingjustbelow0.20%and0.30%(respectively)inthelongrun.Asthe

resultsshow,thebenefitsaregreateriftaxratesarehigherastherearemorelossestobe

harvestedforaneconomicbenefitinthefirstplace!Similar,thebenefitsaregreaterifthemarket

declineislarger,producingmorelossestoharvestandmoretaxsavingsgeneratedinthefirst

placeandthebenefitsarealsogreaterifsubsequentreturnsarehigher(allowingmore

compoundingonthetaxsavings).Conversely,withsmallermarketdeclines,lowertaxrates,and

lowerreturns,thebenefitoftaxlossharvestingisdiminished.

Giventhissomewhatmodestbenefit,itsimportanttoweighthebenefitoftaxlossharvesting

againsttherisks,whichincludetransactionfeesthatmayerodeitsvalue,alongwiththeriskof

trackingerror(thatthealternativesecurityheldtoavoidthewashsalerulesdoesnotperform

consistentwiththeoriginalinvestment).Ontheotherhand,though,astransactioncostscontinue

todeclinetowardszero(withtighterbid/askspreadsandlowtradingfees),andtheriskof

trackingerrorisoftendiminished(aswithtodaysETFs,itseasiertoholdanotsubstantially

identicalsecuritytoavoidawashsalewhilestillmaintainingarelativelyhighcorrelationtothe

originalinvestment),eventhesebenefitsfortaxlossharvestingmakeitsufficienttoconsider

pursuingsystematicallyovertime.

How Tax Bracket Arbitrage Changes The Benefit Of Tax-Loss Harvesting(For Better Or For Worse)

https://www.kitces.com/blog/is-capital-loss-harvesting-overvalued/https://www.kitces.com/blog/harvesting-losses-or-harvesting-gains-planning-around-four-long-term-capital-gains-tax-rates/



Inalloftheaboveexamples,thebenefitoftaxlossharvestingwasmeasuredassumingtaxrates

staythesameatthetimethelossisharvested,andwhenthesubsequentrecoverygainis

recognized(whetherat15%or23.8%).However,therealityisthatsometimes,thetaxrateswill

differ,creatingataxbracketarbitrageopportunityforadditionaltaxlossharvestingbenefits.

Forinstance,assumeinsteadthattheinvestorisatpeakwagesrightnow,boostingoverall

incometothetoptaxbracketsandthecapitalgainsrateto23.8%,butanticipatesretiringsoon

andthattheassociatedcapitalgainsratewillfalltoonly15%fromthatpointforward.Inthis

context,theeconomicvalueofharvestingthelossisnotmerelytheopportunitytoinvestthetax

savingsuntilitmustberepaidfromtherecoverygainwealthcanalsobecreatedsimplybythe

differencebetweenthecurrentandfuturetaxrates.

Continuingtheearlierexamples,thismeansthatwitha$6,000loss,thetaxsavingsat23.8%

wouldbe$1,428,whilethesubsequent$6,000recoverygainwouldonlybetaxedata15%rate

for$900ofsubsequenttaxes.Asaresult,harvestingthetaxlossnow(at23.8%)andrepayingit

inthefuture(at15%)creates$1,428$900=$528offreewealth,simplybyeffectively

timingthetaxrates!

Whenaddedontopofthepuretaxdeferralbenefits,theopportunityfortaxbracketarbitrage

createssignificantadditionalwealthopportunitiesovertime.Thechartbelowshowsacomparison

ofthetaxlossharvestingbenefits(intermsofexcessreturnequivalentmeasuredbythe

differenceininternalratesofreturnbetweenwealthwithandwithouttaxlossharvesting)

dependingonwhethertaxratesareaconstant15%,aconstant23.8%,orahigher23.8%now

andalower15%inthefuture.Astheresultsshow,theadditionalwealthpotentialbytaxbracket

arbitragecanbesignificantlylargerthanthetaxdeferralbenefits(thoughultimatelytaxbracket

arbitragebenefitsdiminish,asthebenefitisstretchedoutovertime).



Anespeciallyfavorableversionofthecomparisonemergesifthereisanopportunityforthe

investortoharvestalossatordinaryincomerates(e.g.,byapplyingitagainstordinaryincometo

theextentofthe$3,000limit,orbyharvestingashorttermlossandhavingshorttermgainsto

offsetitagainst)insuchscenarios,thetaxbracketarbitrageissignificant,withaspreadof43.4%

vs23.8%atthetoptaxrates!

Ontheotherhand,itsworthnotingthattaxlossharvestingcanalsofaceadversetaxbracket

changesaswell.Forinstance,aninvestorharvestingat15%capitalgainsratesmightactually

harvestsomuchinlossesthatthefuturerecoverygainactuallydrivesthefuturetaxbrackets

higher!Forinstance,arelativelyaffluentinvestormightharvest$50,000/yearfor10yearsat

15%rates,butdoingsobringsdownthecostbasisoftheportfoliobyacumulative$500,000,

whichmeansthesubsequentrecoverygainmaybelargeenoughtodrivethatinvestorintothe

top23.8%taxbracket.Suchnegativetaxarbitragescenariosareariskoftaxlossharvesting(if

notplannedfor)andcanbewealthdestructive,oratleastrequiresignificanttimeforthebenefits

oftaxdeferraltoovercometheadversechangeintaxbrackets.Infact,insituationswherefuture

gainsmaybetoolarge,theoptimalapproachisactuallynottoharvestthelosses,buttoharvest

thegainsinsteadsimilarly,forlowerincomeindividualseligiblefor0%longtermcapitalgains

rates,itsbettertoharvestgainsforafreestepupinbasis,ratherthanharvestinglosses!

Acomparisonofthesescenariosincluding23.8%statictaxrates,harvestingat23.8%but

liquidatingat15%,harvestingattopordinaryincomerates(43.4%)andliquidatingattoplong

termcapitalgainsrates(23.8%),andanexampleofanegativetaxarbitragescenarioof

harvestingat15%butliquidatingat23.8%,areshownbelow.Astheresultsrevealoverall,the

benefitsorpotentialadverseconsequencesoftaxlossharvestingwhentaxbracketschange

canbefarmoreimpactfulthantheunderlyingbenefitoftaxdeferralitself!

https://www.kitces.com/blog/is-capital-loss-harvesting-overvalued/http://www.investopedia.com/articles/investing/062713/capital-losses-and-tax.asphttps://www.kitces.com/blog/understanding-the-mechanics-of-the-0-long-term-capital-gains-tax-rate-how-to-harvest-capital-gains-for-a-free-step-up-in-basis/https://www.kitces.com/blog/harvesting-losses-or-harvesting-gains-planning-around-four-long-term-capital-gains-tax-rates/



Itsalsoimportanttonotethatanespeciallyextremetaxbracketarbitrageopportunityis

availableforthosewhoultimatelyplantoeitherdiewiththeinvestmentordonateittheformer

allowsforastepupinbasisthatimplicitlythefuturetaxrate0%,andsimilarlythelatteralso

avoidsanyfuturetaxationontherecoverygainthroughtherulesforcharitabledeductions.Tothe

extentthatthefuturetaxbracketis0%,theassociatedtaxbracketarbitragewillmaketheloss

harvestingoutcomebeevenmorefavorable!

Daily Checking, Diversification, And Other Factors That Impact TheBenefits Of Tax-Loss Harvesting

Thusfar,wehavelookedattaxlossharvestinginwhatisarguablyoneofthemostfavorable

possiblescenariosadramatic30%loss(a2standarddeviationevent!)occursimmediately,in

thefirstyear,creatingasignificantlongtermtaxlossharvestingopportunity,withallthe

associatedbenefitsofcompoundinggrowthontaxdeferralandthepotentialfortaxbracket

arbitrage.However,inmany(orevenmost?)cases,investmentsdontimmediatelygodownright

afterpurchasingthem.Andinfact,ifaninvestmentrisesenoughintheearlyyears,itmaybeso

faraheadthatevenwithasubsequentmarketdecline,therewillbenoloss,astheinvestment

mayalreadybesofaraheadtherethedeclinedoesntactuallytriggeralossbelowcostbasis!



Totheextentthatavailablelossestoharvestinpracticearelowerthantheexamplesshown

previously,thelikelybenefitoftaxlossharvestingformostinvestorswillbesmallerinpractice,all

elsebeingequal.

Ontheotherhand,therealityisthatmostinvestorsdonthold100%oftheirportfolioinasingle

fundorinvestment.Instead,investorsownmultipleinvestmentsinaportfolio,whichmeanseven

ifsomeinvestmentsgoup(possiblyenoughthattherewillneverbelossestoharvestbecausethe

investmentwillneveragainfallbelowcostbasis),otherinvestmentsthatarenotperfectly

correlatedmightstilldeclinebelowcostbasis,creatingalossharvestingopportunity.Broadly

speaking,thismeansthatthemorediversifiedaportfoliois,andthemoregranularthepositions

are(intheextreme,holdingeachofthe500stocksintheS&P500,ratherthananS&P500ETF),

themoreopportunitiestherewillbetodoatleastsometaxlossharvesting.Similarly,ongoing

contributionsintotheportfolioovertimecreatethepotentialthatevenifsomeinvestmentsnever

havealossharvestingopportunity(e.g.,theyareinvestedrightbeforemarketsrisesignificantly),

otherinvestmentsintothemarketmaybelesswelltimedandexperienceearlydeclinesthat

createlossharvestingopportunities.

Similarly,itsnotablethatwhilemanyadvisorsandinvestorshavehistoricallyimplementedtax

lossharvestingonanannualbasis(e.g.,inthemonthofDecember),tryingtoharvestmore

regularlythroughouttheyearcreatesmoreopportunitiestoactuallyharvestatthepointof

maximalloss.Forinstance,in2011theS&P500wasdownmorethan10%inthemiddleofthe

year,butfinishedup2%annualtaxlossharvestingwouldhavefoundnolossestoharvest,but

tryingtoharvestmorefrequentlywouldhavegeneratedsometaxlossharvestingbenefits.While

thereissomedebateaboutexactlyhowmuchadditionallossharvestingopportunitiesarecreated

bycheckingforlossesmorefrequently(somecontendthevalueissignificant,whileothers

suggestitsafairlymodestincrementalbenefit),thereisclearlyatleastsomeimprovementin

practicaltaxlossharvestingefficiencybyseekingoutlossestoharvestmoreoftenthanjustoncea

year.However,investorsshouldbecautiousaboutbeingtooaggressiveinfrequentloss

harvesting,asitisstillpossibletoharvesttoofrequentlyiftheincrementallossestoharvestare

toosmall,theymaybeoverwhelmedbywhatwilllikelystillbesometransactioncostsandbid/ask

http://www.advisorperspectives.com/newsletters14/32-taxharvest2.phphttps://www.wealthfront.com/whitepapers/tax-loss-harvesting#14-comparison_of_daily_vs_one_time_i_e_end_of_year_tax_loss_harvestinghttps://www.kitces.com/blog/indexing-2-0-how-declining-transaction-costs-and-robo-indexing-could-disintermediate-index-mutual-funds-and-etfs/



spreadstocontendwith,andwhiletrackingerrorcanbereducedwithtodaysinvestmentvehicles,

itsnotzeroandshouldntbeignoredeither.

Ofcourse,perhapsthegreatestcaveattotaxlossharvesting,though,issimplythatnoneofthese

moregranularlossharvestingopportunities,ortheabilitytocheckregularlyforlossestoharvest,

willmatteriftherearenocapitalgainstooffsetwiththoselossesinthefirstplace!Underthe

InternalRevenueCode,iftherearenocapitalgainstomatchagainstthelosses,thenupto

$3,000oflossescanbeappliedagainstordinaryincome,buttheremaindermustsimplybecarried

forwardforfutureuse,generatingnotaxdeferralsavings,noopportunityforcompounding

growth,andnopotentialfortaxbracketarbitrageatall!Infact,formanyinvestors,harvesting

losseswhentherearenogainstooffsetsimplycreatescarryforwardlossesthatjustgetusedin

thefuturetooffsetthegainscreatedbyharvestingthelossinthefirstplace,whichproducesno

economicbenefitstoharvestingthelossatall!

Thebottomline,though,issimplythis:taxlossharvestingdoeshavesomeeconomicbenefitover

time,althoughitsdrivennotbytheoutrightsavings(typicallymeasuredbytaxalpha),but

insteadbytheeconomicvalueoftaxdeferral,whichleadstomodestbutnontrivialeconomic

benefitsovertime.Forthosewhomayexperiencetaxbracketchanges,thebenefitscanbe

significantamplifiedforbetterorworseandinfact,theimpactoftaxbracketarbitragecanbe

manytimesmoresignificantthantheunderlyingbenefitsoftaxdeferralitself.Asaresult,its

crucialtofocusnotjustonthetaxdeferralvalueoflossharvesting,butalsothepotentialtax

bracketimpactsandtotheextentanyanticipatedtaxbracketchangesarefavorable,andthere

aregainstooffsetwiththelossesinthefirstplace,harvestasmuchaspossible,maximizingthe

opportunityforeachcontribution,eachinvestment/assetclassbeingheld,andbycheckingfor

lossharvestingopportunitiesasoftenaspossible!

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Einstein 3monthsago

It'shardtoimaginewhatelsecouldbesaidonthesubjectoftaxharvesting.Atthistimeofyear,Ireviewrealizedandunrealizedgains/lossesformyclients,butonlyharvest,ifitcallsforatradeinlinewiththepreviouslyplannedallocation.MaybeImakeatradeinDecemberratherthanlater.Sometimesthereisaparticularsituation,buttaxesaregenerallyinthebackseat..

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