Reducing tax liabilities without altering exposure can be a straightforward task.
Though the unofficial tax season ends in mid-April, the filing deadline is really a summary of the numerous investing events that occur throughout the year. It’s the final scorecard to measure the effectiveness of an investor’s tax strategy.
Many investors assume that their tax liabilities from year to year are beyond their control. This assumption is a faulty and potentially costly one. In reality, maximizing tax efficiency is one of the two actions an investor can take that consistently and directly impacts the bottom line return. (Minimizing fees is, of course, the other.)
ETFs have become so popular over the last decade in part because of the low costs and built-in tax efficiencies related to the ability to execute in-kind redemptions. ETFs can also be used to execute a more manual tax strategy: harvesting losses. If done correctly, investors can reduce or eliminate capital gains liabilities without materially altering the composition of their portfolio.
Tax Loss Harvesting 101
The concept of tax loss harvesting is simple: when facing a liability related to a capital gain (i.e., when a stock or fund has been sold for a profit), investors can sell a position that has an unrealized capital loss in order to offset part or all of the expected taxes due.
In order for this strategy to be practical, an investor should typically have:
- A realized capital gain. For example, an investor may have sold AAPL stock purchased for $100 at a price of $125. For 1,000 shares the realized taxable capital gain would be $25,000.
- An unrealized capital loss. For example, an investor may have purchased shares of MCD at $105 that are now trading for $90. For 1,000 shares the unrealized capital loss would be $15,000.
A capital loss from the sale of stock or funds can be used in multiple ways, including to:
- Offset capital gains;
- Offset up to $3,000 of ordinary income; or
- Carry forward indefinitely for use in future years.
Navigating the “Catch”
In order for a capital loss to qualify, it must pass the wash sale rule. This rule effectively states that an investor can’t sell a position, book the loss, and immediately repurchase the same security that was just sold. There is a mandatory 30-day period before the sold stock or fund can be added back to a portfolio. The investor has two primary options for the proceeds of the sale:
- Leave in cash for 30 days; or
- Purchase another security.
This waiting period can be problematic for a number of reasons. Most importantly, it disrupts the asset allocation strategy in place by forcing an investor to reallocate a section of a portfolio to cash or an alternative asset. Sitting in cash creates a possibility of missing out on any gains. While the month-long window may seem relatively short, it is plenty of time for major movements to occur. During its best 43 trading sessions, the Dow Jones Industrial Average added 18,000 points — more than the total to which it has worked over more than a century. Market timing, even for just a few weeks, can be a bad idea.
Thanks to the increase in the sheer number of ETFs in recent years, however, there are some relatively straightforward ways around this. Specifically, an optimal tax loss harvesting strategy involves using the proceeds to purchase an ETF that is highly correlated with — but not identical to — the one that was sold. An example of this strategy in action is highlighted below.
The IRS stipulates that investors can’t replace a sold security with “substantially identical stock or securities.” But there are often ETF alternatives to a security that can be used to maintain generally similar exposure without raising a red flag at the IRS.
Tax Loss Harvesting Example
Below is an example of the concepts outlined above, using an investor in position to reduce the current year’s tax liability by harvesting an unrealized loss. Assume a hypothetical portfolio consisting with core positions in SPY and AGG and smaller holdings in a Biotech ETF (IBB) and Energy ETF (XLE):
This hypothetical investor made a very smart bet on biotech at the bottom of the last recession, and is now sitting on a huge unrealized gain. The $5,900 investment made in March 2009 is now worth $34,000, of which $28,100 represents a taxable capital gain.
Assume that this investor is worried about a bubble in biotech, and wants to lock in this gain by liquidating the position in IBB. In the 15% tax bracket, this would mean a tax bill of $4,215. But there is an opportunity to harvest an unrealized loss in order to offset part of this liability.
The positions in SPY and AGG represent unrealized gains, but XLE is trading for less than the original purchase price. This investor could realize a long-term capital loss of $25,000 now by selling all 1,000 shares. This would offset almost all of the gain associated with IBB, and reduce the total tax liability to just $465-much lower than the $4,215 bill this investor would be facing otherwise.
Maintaining Energy Exposure
There is, of course, one problem with simply liquidating the position in XLE to offset the taxable gain in IBB. In order for the loss to qualify, the investor cannot re-establish that position in XLE for 30 calendar days.
This is an inconvenience, because the investor presumably wants to maintain exposure to this asset class. Sitting on the sidelines for 30 days disrupts the overall strategy, and would cause the portfolio to miss out on any price appreciation during that time. Purchasing a different asset class (such as tech stocks) shifts the overall allocation, so this isn’t ideal either.
The solution here is to buy a different ETF that is highly-correlated to XLE. In this case, there are several options for exposure to the U.S. energy sector. These funds aren’t identical-they may vary in weighting methodology and number of components for example-but the overlap will be very high and the correlation will be nearly perfect.
Three such options for this specific example would be the iShares U.S. Energy ETF (IYE), the Vanguard Energy ETF (VDE), and the First Trust Energy AlphaDEX Fund (FXN). All three of these ETFs have correlations with XLE of 0.96 or higher.
This solution may not be quite perfect; after all, the investor elected to hold XLE instead of IYE, VDE, or FXN in the first place. It’s possible that holding one of these alternatives for 30 days will result in some lost capital appreciation. But any performance difference over a short period will likely be negligible, and almost certainly less than the tax offset gained.
Loss Harvesting with ETFs vs. Stocks and Mutual Funds
Tax loss harvesting is not specific to ETFs. In the example above, the hypothetical investor could have easily purchased an energy mutual fund or Exxon Mobil (XOM) stock instead of another ETF. The mechanics would work in an identical fashion if the loss being harvested was in the Fidelity Select Energy Portfolio (FSENX) instead of in XLE. There’s no rule that offsetting losses must come from the same type of security as the taxable gains.
The primary advantage of using ETFs to execute this strategy relates to the high correlation between different types of securities. For many strategies, there are multiple ETFs that are similar enough to exhibit high correlation but not so similar as to qualify as “substantially identical” and thus invalidate the loss.
It should be noted that this move doesn’t eliminate the tax liability, but rather delays it. The accrued loss in XLE now can’t be used in the future, and any gains in the new ETF position will be taxable when that position is ultimately liquidated. But there is value in such a move to delay tax liabilities as long as possible.
About the Author: Michael Johnston
Michael Johnston is senior analyst for ETF Reference, and also serves as COO of parent company Poseidon Financial. His investment expertise has been featured in The Wall Street Journal, Barron’s, and USA Today, among other publications. He resides in Chicago.