As stocks tumble, this tax play offers a silver lining

Stocks are sliding. But there may be a silver lining for investors.

An investment loss poses an opportunity to trim your annual tax bill, via a mechanism called tax-loss harvesting.

Here’s the basic premise: You sell an investment that’s in the red, and then use that investment loss to offset earnings on winners — thereby reducing or erasing annual capital-gains taxes.

There are additional benefits: If losses exceed annual gains, investors can use the remainder to offset up to $3,000 of ordinary income (like wages) from federal tax. Anything left over can carry forward to future tax years, to offset capital-gains taxes or tax on ordinary income.

Many investors may be able to leverage this strategy in the current market.

Major U.S. stock indexes have declined for at least five consecutive weeks as investors grapple with potential economic headwinds like war, inflation and rising interest rates. The S&P 500 index is down over 15% in 2022. The Dow Jones Industrial Average has fallen more than 10%, and the tech-heavy Nasdaq Composite over 24%. Stocks extended their losses Monday morning.

“Now may be the time to do it,” Paul Auslander, a certified financial planner and director of financial planning at ProVise Management Group, said of tax-loss harvesting. “Any time there’s a window, you want to take advantage of it.”

The best way to execute the tax-loss harvesting strategy is to balance out losses with gains, Auslander said. This way, income on winners is essentially free.

There are a few caveats, though.

For one, investors shouldn’t sacrifice their overall investment goals to save some money on taxes.

They should also check whether their losses and gains are “short term” or “long term” (meaning, whether the investments have been owned for less or more than a year). Short-term losses generally only cancel out gains on short-term investments, though not always. And using a short-term loss to offset a long-term gain may not be efficient, since long-term earnings carry a preferential tax rate.

Investors may also lose the tax benefits of the strategy if they trip “wash sale” rules.

These anti-abuse rules prohibit investors who sell a losing investment from buying back the same or “substantially identical” security within 30 days before or after the sale. Otherwise, the IRS may disallow the tax benefit.

This means investors have two choices: They can park their sale proceeds in cash for 30 days or use them to buy an investment that isn’t “substantially identical.”

The “substantially identical” definition is somewhat fuzzy. Selling 1,000 shares of Meta stock and immediately buying more Meta shares is a clear no-no. But what about buying other stocks like Snapchat or Microsoft within the 30-day window? The IRS may frown on that since they (like Meta) are technology stocks, Auslander said.

But the investor can almost certainly buy stock in a company like Boeing without drawing IRS ire, since the companies aren’t in the same industry category, Auslander said.

Similarly, selling out of one stock-index-tracking fund for another (say, exchanging an S&P 500 fund for a DJIA fund) likely wouldn’t fly. But selling a growth-oriented stock fund for one with a value tilt would likely be fine, Auslander said.

And if you sell 1,000 shares of a stock or fund, it may be wise to purchase a different number of shares (maybe 900 or 1,100 shares) of the new investment (if within the 30-day wash-sale window).

However, the best approach in the current market may be to avoid triggering these rules altogether — by sitting in cash for 30 days. Given the current market volatility, being out for a month or so likely won’t cost investors much if any return, Auslander said.

“Because the definition [of ‘substantially identical’] is a little vague, why put the taxpayer in that position?” he said. “I’d make a strong case for sitting in cash and waiting.”