The S&P 500 just entered record setting territory. The broadest financial index’s average is over 2000 for the first time in history. Whether you believe this bull market is for real or inflated, the fact of the matter is that right this very moment it is very possible that if you are invested in the market you have made some money. As this rally is going on, you may have heard something called harvesting your gains or losses. This phrase can mean different things to different people. This article will discuss just what “harvesting gains and losses” means for tax purposes.
When preparing tax returns a few years back, it was common to see my clients with several thousands of dollars in losses on their Schedule D. Schedule D is where you report short and long term capital gains. Here is the problem with capital losses; you can only deduct $3,000 per year. If you have a capital loss of $25,000 you can only deduct $3,000 of that loss and the additional $22,000 carries forward to the next tax year. This amount will be able to be taken in $3,000 increments until used up. For example, the $22,000 loss that was carried over, only $3,000 of it can be used in the following year with $19,000 carryforward to the next year, and so on. However, if you had a $25,000 capital gain, you would have to report and pay tax on all $25,000. Doesn’t make sense does it? Capital gains, can only be reduced by capital losses. Using the previous example of the $22,000 capital loss carryforward, if in the next year you had a capital gain of $10,000, it would be reconciled with the capital loss, giving you a $3,000 capital loss on your tax return and $9,000 to carryforward to the next year.
Enter harvesting gains. If you are carrying forward a large capital loss, and you have a security that has gained a lot of money, and you want to sell it to take some of the gain, you could do that with minimal, if any tax consequences. For instance in 2013 you had a $75,000 capital loss carryforward. In 2014 you have a gain in your brokerage account of $55,000. You could sell the security and still report a $3,000 capital loss on your tax return. In short you would not pay any capital gains tax. Thus you have harvested the gain without paying capital gains. That is pretty cool right?
Harvesting a loss is a little different. Let’s say that you did not have a capital loss carryforward from the year before, but this year you have a capital gain of $75,000. However, you also have a security in your portfolio that has lost big. The capital loss is $25,000. You don’t think this security will ever come back, so you “harvest the loss” and sell the security. On your tax return you will only have $50,000 that is subject to capital gains tax.
Harvesting gains and losses is something that I do for my clients all the time. Your tax accountant and your financial planner should know one another, and should have a good working relationship. At the end of every year, I go through my client’s investment statements with their financial adviser and we harvest gains and losses.
All of this sounds great. Where do you sign up? I want to point something out, because it would be malpractice not to do so; be careful of Alternative Minimum Tax (AMT) when harvesting gains and losses. AMT is a ticking time bomb. It is not alternative and it certainly isn’t minimum. Without boring you to death, the best explanation of AMT is that it is an alternate way of calculating your taxes. If you have too many preferential tax items on your tax return, you will trigger AMT. This would be triggered on long-term capital gains because the tax you pay on them is lower than your ordinary tax bracket. Note that not all people will be subject to AMT for harvesting gains and losses, but some will. Before you implement a gain or loss harvesting strategy, you really should sit with a competent tax professional to access the risks of falling into AMT.
I hope that this article has cleared up exactly what harvesting gains and losses actually means.