Using Tax Loss Harvesting to Benefit Big From Downturns

How I Used Tax Loss Harvesting with Real Estate During COVID

Is tax loss harvesting with real estate even possible? Yes! You can use a smart tax loss harvesting strategy to finance a real estate buy. During the first wave of COVID in March 2020, I found myself (like many others) wanting to buy a better, bigger house. But the market was DOWN–really down. In fact, the market had literally crashed.

As you might recall, the crash began February of 2020 and lasted to April 2020. Monday, March 9, 2022 was the largest Dow Jones Industrial Average (DJIA) record-setting drop in history (at that time), followed by two more record-setting plunges occurring directly after on March 12 and March 16.

It was a crazy, hard time for a lot of reasons.

This topic is relevant now because of the current market conditions at the time of writing this post (March 2022). In February 2022, the S&P 500 plummeted nearly 12% from an all-time high (year-to-date).

Making Lemonade Out of Lemons

I needed to free up some cash in a tax-friendly way to add to bring my total cash to enough to buy my next home free and clear. I had had a really good run and my ETFs had racked up quite a bit of unrealized capital gains. I really didn’t want a big capital gain tax headache to deal with in the next year, so I used tax loss harvesting to pull out cash from my ETF portfolio during the Big Crash of 2020 without incurring a big tax debt later on.

So, yes, using tax loss harvesting with real estate–to finance the buying of real estate is real and possible. Buying real estate, for personal use or investment requires good tax planning, especially when you need to make a cash downpayment and you don’t have the cash sitting around waiting. Tax loss harvesting can be part of a smart tax strategy.

Making Large Withdrawals the Right Way

There are ways to do it successfully and not so successfully. You definitely need to be on the right side here and set yourself up correctly from the start. Schwab has a good article about the 3 mistakes to avoid when making a large portfolio withdrawal (withdrawing the money all at once, avoiding tax losses, ignoring competing financial goals). Tax loss harvesting was my way in that crazy, down market.

What is Tax Loss Harvesting?

Tax-loss harvesting (or “tax swaps”) is the act of selling securities at a loss to offset a capital gains liability. If an investor still wants a similar allocation in their portfolio, they can then purchase a mutual fund or ETF that tracks the sector associated with the particular securities that have been harvested. This is referred to as rebalancing. (Of course, you can use tax loss selling as a time to adjust or re-adjust your asset allocations.)

Time it by the End of the Tax Year

It is most commonly used as an end-of-the-year tax strategy to capitalize and benefit from capital losses before the tax year ends by offsetting capital gains with capital losses. There is often a big surge at year end of stock selling exactly for this purpose.

You can do this strategy at any time during the tax year, up until Dec 31 (but remember that many stock markets close early on December 31 and you may not be able to record a transaction on that day).

For general info on capital gains and losses, see IRS Topic No. 409 Capital Gains and Losses.

Re-Balancing ETFs

Being careful not to change my asset allocations much, I tracked and then matched up my buys and sells on a spreadsheet. I waited for opportune moments to buy and sell; meaning, the transactions did not occur on the same days in some cases so it was important to me to keep track of rebalancing.

How to Find Similar But Not “Substantially Identical” Investments

To be acceptable to the IRS, securities must be different enough to be seen as separate investments. It is also very important to find similar-grade, high quality investments to swap with when doing tax loss selling. There are several criteria you can use to differentiate between two similar investments:

• the fund managers or investment team are different
• the expense ratios vary for each investment
• the underlying index is the same but uses a different methodology to calculate and manage
• different levels of liquidity in the market

Use a Stock, Fund or ETF Screener

Online brokers offer screeners which you can use to find several choices of equivalent investments. For example, Schwab has a research tool for ETFs that you can use to find ETFs listed by category: Commodities, International Equity, Municipal Bonds, US Equity, and more. You can also use the Stock Compare tool and enter your investment, then click the Popular Competitors link to find industry peers based on industry and market capitalization. You can compare by Company or Index to find a list of comparable securities.

Use a Fund Overlap Tool

One way to determine if investments are similar but not substantially identical is to run the two possible investments through a Fund Overlap tool like the one found at the ETF Research Center. Fund Overlap Tools make it a lot easier to see the true overlap between funds.

For example, using the ETF Research Center Overlap Tool, you can identify what the two equity ETFs (like VTI and SCHB) have in common, along with the top differences in their exposures. In the case of VTI and SCHB, even though they have considerable overlap in their holdings and mimic the same index, they should be acceptable since they are issued by and through different companies.

Note that you can also use the Fund Overlap tool as a general portfolio evaluator to determine if you are over-invested in any particular holdings or financial sectors, across ALL the accounts in your portfolio, even investments with different brokers or ones invested at your company (like a 401K, for example).

Here Is How the Tax Numbers Came Out

See below for my short-term cap loss and long-term cap gain exposures.

Short term Capital Loss Sale of ETFs (Schwab): -5,644.16

Long-term Capital Gain Sale of ETFs (Schwab): $6655.61

NET Capital Gain = $1011.45

You can use this Capital Gains Calculator from Turbo Tax Intuit to calculate your capital gains. There are many other capital gains calculators around on the web, but this one is very easy to use, especially if you are already a regular Turbo Tax user. Calculating your approximate tax liability before you make any sells is a good strategy.

How Can You Benefit from Tax Loss Selling?

If done correctly, tax loss selling can lower tax liability on your investments, but there are limits to how much losses you can take in a given year. You can only offset taxable income with tax losses by $3,000 per year if married, $1,500 if single or married, filing separately.

Take Advantage of this One-Time, Tax-Free Transfer

What Are the Pros and Cons of Tax Loss Harvesting?

The Pros

The biggest pro is reduction in capital gains taxes. Capital gains come in two flavors: long term and short-term.

A long-term investment is held for more than 365 days and taxed at capital gains rates, not earned income rates, which is usually quite a bit more favorable, tax-wise. A short-term investment is sold in less than 365 days, and taxed at the income tax rate.

The long term capital gains rate can change, and it depends on current law. As of 2022, the current long term capital gains rate is set to 0 percent, 15 percent and 20 percent, depending on your income, meaning the most you could possibly pay is 20%, even if your income is extremely high.

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The Cons

You must rely on your own judgment (and the advice of tax professionals) when deciding if a particular security is “substantially identical” to another security, because unfortunately, the IRS does not provide clear guidance on that subject. This is one of the biggest drawbacks to tax loss harvesting.

Wash Sale Rules

A wash-sale is when you buy the same shares back within 30 days of the date you sold them. Selling shares and then turning around and buying that same company’s shares within 30 days of the sale clearly violates the Wash-Sale Rule. However, some situations involving the same issuing corporation are not as clear and could be problematic: for example, if you bought and then sold different classes of stock (from the same corporation), or if you sold common shares and then bought preferred shares (or vice versa).

Unexpected Long Term Rate Hikes

Another drawback or con could be a change in the long term capital gains rate. Perhaps you recall in September of 2021 when House Democrats proposed a rate hike of 28.8% for top earners (single filers with taxable income over $400,000 and for married couples at $450,000). Depending on the amount of selling you are doing, this could amount to a substantial hike in taxes.

The Biggest Thing Against Tax Loss Harvesting as a Strategy

The biggest thing against tax loss harvesting is that you might not win when you have to defend your positions as “substantially different” to the IRS. Another concern is fees associated with trading (buying and selling). If these fees are considerable, selling and rebalancing by buying a large amount of stocks in a portfolio can be costly.

Most robo advisors are now set up to include and perform automated tax loss selling. This is one way to alleviate the concerns of picking the securities yourself, protecting your from close IRS scrutiny. These systems are set up to do the selling and buying in a highly efficient way, and keep very good records for you so you don’t have to be as organized as when you are managing this on your own.

Stay Ahead of the Wash-Sale Rules

Waiting 31 days to buy shares of the same security is outside of the Wash-Sale Rule and is not subject to it. It is possible, therefore, to sell a stock or ETF, and then buy a different stock or ETF that mimics a similar risk-return allocation. After 30 days, the original stock could be repurchased.

However, the downside is real. You can’t always or may not want to wait 31 days to buy the same stock or ETF. Consider instead buying a similar but not substantially identical stock or ETF and beat this rule cold.

Keep Solid Records

Keep records of all your transactions, organized by stock or ETF, and the reasoning you used behind each tax loss harvesting transaction. You will need to keep these records for at least ten years. Remember, some investment brokerages only keep easily downloadable records for only five years and the IRS might try to reach back further than that.

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Disclaimer: All the information provided above  and on this site is for informational purposes only and should not be considered as professional investment, legal, or tax advice. You should conduct your own research or consult with a professional financial advisor when investing.

Remember, past performance is not a guarantee or indication of future performance. Any investment involves the risk of loss.

Photo by Colton Sturgeon and Andrew S and Mathias Reding on Unsplash