You might be familiar with the term tax-loss harvesting, particularly if you have done any research into robo-advisors. Many of them now offer the service, either to larger account holders, or even across the board. But tax-loss harvesting has a counter strategy, known as tax-gain harvesting.
Tax-gain harvesting vs. tax-loss harvesting
Let’s start by explaining tax-loss harvesting, since it is likely to be the more familiar of the two topics.
Tax-loss harvesting involves selling one investment at a loss, in order to offset gains on the sale of other investments. The idea is to use those losses to offset capital gains on winning investment positions and reduce capital gains taxes.
After the losing investment position is sold to generate a loss, you buy into a similar—but not identical—investment position. In doing this, you are creating the loss that offsets your capital gain on the winning investment, while retaining a (similar) position in the losing investment for future growth.
In a perfect world, you can do this year after year, and never incur capital gains taxes. In the process, you will sell winning investments, and substantially retain losing investments until they become winning investments as well.
The flipside of tax-loss harvesting, is tax-gain harvesting. This is a strategy in which you sell winning investments specifically to capture capital gains. So why would you do that, considering that those gains will also a create capital gains tax liability?
Generally, you use tax-gain harvesting when your current capital gains tax rate is lower than what you expect it will be in the future.
That is, you sell a winning investment now and pay the tax (or incur no tax), rather than paying a higher tax at a later date.
The benefits of tax-gain harvesting
Depending upon your own personal income tax situation—as well as the level of potential capital gains in a given year—tax-gain harvesting could save you many thousands of dollars.
Part of this has to do with the fact that there are two (technically three) different rates at which capital gains are taxed. Long-term capital-gains tax rates look like this in 2016 (the tax rate applies to both qualified dividends and the sale of appreciated assets held for longer than one year):
- 15 percent for single filers with taxable incomes of up to $415,050, and married couples filing jointly with taxable incomes up to $466,950
- 20 percent for single filers with taxable incomes exceeding $415,050, and married couples filing jointly with taxable incomes exceeding $466,950
What’s more, if you are single and your taxable income does not exceed $37,650, there is zero tax on long-term capital gains income below the income threshold. And if you’re married filing jointly, there is zero tax on long-term capital gains on total income of $75,300 or less.
As an example, if you are married filing jointly, and have other income of $60,000, but also have an investment that would produce a capital gain of $10,000 in 2016, you might choose to sell that investment this year, rather than waiting until 2017, when you anticipate that your other income will be in the $100,000 range.
Since the $10,000 gain will produce a zero tax liability in 2016 (since your total income will be $70,000), and delaying into 2017 will result in a 15 percent capital gains tax on the sale, you will save $1,500 ($10,000 X 15 percent) by selling the investment and realizing the gain in 2016 rather than waiting until 2017.
Repurchasing a similar investment
This is where the “harvesting” part of tax-gain harvesting takes place. You aren’t entirely eliminating your winning investment position, you are merely harvesting the gain accumulated to date to take advantage of a more favorable capital-gains tax rate. In that regard, the couple above can buy the investment using the proceeds from the sale of the original investment. That will give them a stepped-up cost basis on the new investment position, which will lower their capital gains when it is sold in the future.
By using tax-gain harvesting, the couple are able to realize the gain on the sale with zero tax liability in 2016, while still maintaining an equivalent investment position going into the future. Nothing’s been lost, and no taxes have to be paid.
Anticipating higher capital gains tax rates in the future
Still another scenario in which you may want to engage in tax-gain harvesting is if you expect that capital gains tax rates will be higher in the future than they are right now. That consideration is hardly out of the question.
Every few years, politicians and the media join forces in debating which taxes need to be increased, and how high they should go. Since investment income is normally associated with the wealthy, it is a frequent target for tax increase talk. Capital gains are one of the favorite options.
And in fact, by historical standards, current capital gains tax rates are quite low. For example, the capital gains tax rate was 35 percent throughout most of the 1970s. It was 28 percent from 1987 to 1997, when the top rate was lowered to 20 percent, where it is today.
There’s no way to know today how high capital gains tax rates will be in a few years – or even where they’ll be next year. But if you have any reason to believe that they will increase, particularly in your income tax bracket, you may want to implement a tax-gain harvesting strategy that will take advantage of today’s lower capital-gains tax rates.
This rule actually doesn’t apply when it comes to tax-gain harvesting, because the rule applies specifically to investments that are sold to generate losses, then immediately repurchased. But we’re including a mention of it here because it does apply when it comes to tax-loss harvesting, and we don’t want you to think that it applies equally with tax-gain harvesting.
The wash-sale rule is an IRS ruling designed to to prevent taxpayers from creating tax losses using investments. The rule requires that a loss on sale will not be permitted if the same or substantially identical security is purchased within 30 days of the transaction that resulted in the loss. That means either 30 days before the sale, or after.
Again, it doesn’t apply to tax-gain harvesting.
Are there downsides to tax-gain harvesting?
Tax-gain harvesting could become a problem under the following circumstances:
If you have very large capital gains
If you have a very large capital gain, that will move you above the 0 percent capital gains tax rate, and make a large portion of the gain taxable (at 15 percent).
If you owe state income taxes
These often have different rules in regard to capital gains, so you may incur a state capital gains tax liability even though you have zero liability for federal tax purposes.
If the gains move your income or deduction thresholds
Since the additional capital gains income will raise your adjusted gross income, it may make certain tax deductions less deductible. For example if you have substantial medical expenses, which are deductible only to the degree that they exceed 10 percent of your adjusted gross income, the additional capital gains income might cause you to lose that deduction. As well, the increased income could make more of your Social Security benefits taxable.
When considering whether or not to engage in tax-gain harvesting, be sure to take these potential outcomes into consideration. The tax code is sufficiently complicated that you could conceivably create an unexpected tax liability in the process of trying to reduce another.
You can get help in making this determination, either by asking your tax preparer to run the numbers, or by using tax software, such as Turbo Tax’s TaxCaster: Free Tax Calculator to see what the impact of the capital gains will be on your entire income tax picture.
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