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Tax-loss harvesting: capital gains and losses

ARTICLE | August 11, 2022

Tax-loss harvesting is a strategy that enables a taxpayer to reduce taxes by using losses to offset gains or income. While taxpayers often wait until the end of the year to assess gains and losses, the opportunity for tax-loss harvesting can happen at any time throughout the year. This article will provide an overview of capital gains and losses and explain how tax-loss harvesting benefits taxpayers.

Capital gains and losses

Capital gains and losses are realized when an asset is sold for a price that is different from the price at which it was purchased. Capital gains are realized when an asset is sold for a higher price than the purchase price, while capital losses occur when an asset is sold for a lower price. 

What are capital and non-capital assets? 

Capital assets are property that is held for investment purposes or use in production. They can be physical objects, such as a house or car, or financial assets, such as stocks and bonds. 

Non-capital assets, on the other hand, are all other assets that are not classified as capital assets. Non-capital assets include: 

  • Stock in trade or other property included held mainly for sale to customers;
  • Accounts receivable acquired in the ordinary course of business for services rendered or from the sale of stock or other property held mainly for sale to customers;
  • Depreciable property used in a trade or business, even if it is fully depreciated;
  • Real estate used in a trade or business;
  • Intellectual property; and
  • Supplies regularly used in a trade or business.

It's important to understand the distinction between capital and non-capital assets because capital assets are subject to different rules than non-capital assets. For instance, capital gains - profits realized from the sale of a capital asset - are generally taxed at a lower rate than the sale of a non-capital asset. 

Short-term versus long-term capital gains and losses

Capital gains and losses must be separated according to how long you held or owned the asset because short-term holdings are taxed differently than long-term holdings. 

The holding period for short-term capital gains and losses is one year or less. Short-term capital gains are generally taxed at the same rate as your ordinary income, anywhere from 10% to 37%, depending on taxable income.

Tax Rate

For Single Filers

For Married Individuals Filing Joint Returns

For Heads of Households

10%

$0 to $10,275

$0 to $20,550

$0 to $14,650

12%

$10,275 to $41,775

$20,550 to $83,550

$14,650 to $55,900

22%

$41,775 to $89,075

$83,550 to $178,150

$55,900 to $89,050

24%

$89,075 to $170,050

$178,150 to $340,100

$89,050 to $170,050

32%

$170,050 to $215,950

$340,100 to $431,900

$170,050 to $215,950

35%

$215,950 to $539,900

$431,900 to $647,850

$215,950 to $539,900

37%

$539,900 or more

$647,850 or more

$539,900 or more

Long-term capital gains and losses

The holding period for long-term capital gains and losses is more than one year. By holding capital assets for more than a year, taxpayers can reap considerable tax savings. For assets held for more than a year or inherited assets, the long-term capital gains tax rates are 0% to 20%, depending on income level.

Tax Rate

For Unmarried Individuals

For Married Individuals Filing Joint Returns

For Heads of Households

Estates and Trusts

0%

$0 to $41,675

$0 to $83,350

$0 to $55,800

$0 to $2,800

15%

$41,676 to $459,750

$83,351 to $517,200

$55,801 to $488,500

$2,801 to $13,700

20%

$459,751 +

$517,201 +

$488,501 +

$13,701 +

Applying capital losses to gains

In any given tax year, capital losses are applied to capital gains, resulting in a net loss or gain for the year. However, if you have a mixture of short and long-term gains and losses, there is an order in which they are applied.

Long-term losses are first applied to long-term gains, and short-term losses are first applied to short-term gains. Excess losses of one type can be applied to gains of the other type. For example, a taxpayer sells three assets which results in a $10,000 long-term gain, a $22,000 long-term loss, and a $5,000 short-term gain. The $22,000 long-term loss is first applied to the $10,000 long-term gain. The excess $12,000 long-term loss is then applied to the $5,000 short-term gain.  

Applying excess loss to ordinary income and carry-forward

If the taxpayer has an excess loss after applying capital losses to capital gains, the excess loss can be deducted from ordinary income up to $3,000 for individuals or married couples and $1,500 for married couples filing separately. Even if there is no ordinary income to offset it, the capital loss must still be deducted.   

Any capital loss in excess of those limits may be carried forward to future years to offset future gains and income.

Tax-loss harvesting

No investor likes seeing an asset lose value, but tax-loss harvesting may provide a benefit. Taxpayers may consider selling assets with losses to offset gains from other assets. Alternatively, taxpayers with carry-forward losses from 2021 may want to harvest some capital gains that the losses can offset since capital losses are limited to $3,000 (or $1,500 for married filing separately). 

Assets that have lost value, have little prospect for future growth, no longer fit with an investment strategy, or can be replaced by more attractive assets are all candidates for tax-loss harvesting. However, be careful of the wash-sale rule, which prohibits a taxpayer from buying the same or "substantially identical" security within 30 days of selling an asset. Violating the wash-sale rule will result in the IRS disallowing the loss from the asset sale.

Taxpayers should consider the long-term versus short-term capital gain tax rates when tax-loss harvesting. If a taxpayer has long-term capital losses in excess of long-term capital gains, applying the excess loss to short-term capital gains is beneficial. The maximum tax rate for a long-term capital gain is 20% versus 37% for a short-term capital gain. Alternatively, applying excess short-term capital losses to long-term gains is less beneficial.  

Before acting on these, or any other strategy, we recommend you call one of our expert advisors and discuss how the strategies will impact your taxes. Due to the many tax brackets, phasing in and out of tax law at different income levels, and many other factors, the actual results will vary with each taxpayer.

How do mutual funds work with respect to capital gains and losses? 

A mutual fund is a regulated investment company generally created by "pooling" funds of investors to allow them to take advantage of a diversity of investments and professional management.

Shares in a mutual fund are generally acquired at various times, in various quantities, and at various prices - making it slightly more complex to determine capital gains and losses. When shares of a mutual fund are sold, it is necessary to determine which shares were sold and the basis of those shares. You can use either a cost basis or an average basis to calculate the gain or loss.

Cost basis for mutual funds

Cost basis can be used only if you did not previously use an average basis for a sale of other shares in the same mutual fund. To figure cost basis, you'll either have to identify specific shares or use the "first in, first out" method. 

Specific share identification

The adjusted basis of specific shares can be used to calculate gain or loss if those shares are adequately identified. Adequate identification requires you to:

  1. Specify to a broker or other agent the particular shares to be sold at the time of the sale, and
  2. Receive confirmation in writing from the broker or agent within a reasonable time of the specification of the particular shares sold.

First in, first out (FIFO)

If the shares sold cannot be identified, the oldest shares owned are considered to be sold first.

Average basis for mutual funds

Average basis is calculated by dividing the total cost of shares owned by the total number of shares owned. Once average basis is used to report gains or losses from a mutual fund, it must be used for all accounts in the same fund. However, you may use a different method of calculating the basis for other mutual funds, even if they are within the same family of funds.

Transfer or exchange of mutual fund shares

Any exchange of shares in one fund for shares in another is treated as a sale. This is true even if shares in one fund are exchanged for shares in another within the same family of funds.

The purpose of this article is to provide an overview of capital gains and losses and tax-loss harvesting. It is not a substitute for speaking with one of our expert advisors. If you would like to discuss your unique situation and what strategy might be most appropriate for you, please contact our office.

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HMA CPA offers a full range of tax, accounting and consulting services for closely held businesses, their owners, and high net worth individuals. We value relationships and are committed to providing close, personal attention to our clients. Though our experience spans over 35 years in the accounting field, we also keep current with ongoing professional education so we can provide you with outstanding technical support and customer service.

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