Realized Capital Loss 101

Investors are always learning.

One area that can be particularly challenging is gaining a better understanding of how our investments fold into the tax equation.

One such scenario is when a portfolio realizes a capital loss, also called tax loss harvesting.  Tax loss harvesting is a strategy with benefits that even some tax professionals may not understand. Here is a definition from Betterment:

“Tax loss harvesting is the practice of selling a security that has experienced a loss. By realizing, or “harvesting” a loss, investors are able to offset taxes on both gains and income. The sold security is replaced by a similar one, maintaining the optimal asset allocation and expected returns.”

At first glance, one may conclude that a capital loss is a sign of an unsuccessful year.  However, this couldn’t be further from the truth.

Why would an investor want to realize a capital loss?

First, there is a deduction of your capital loss against ordinary income.  For federal tax purposes, you apply $3,000 against ordinary income.  If you have social security, IRA distributions or other earned income that would otherwise be taxable, you can have at least $3,000 in capital losses in excess of capital gains.  In addition, there is a $5,000 deduction that can be taken on the state of Wisconsin tax return as well. These are a couple of benefits, but they may not be the most significant advantage.

The biggest advantage for individuals is when they have a capital loss and, if it’s on your books, it carries forward for at least 5 years and “may carry forward for future years”.  Visit www.irs.gov for more information of both capital gains and losses that match your unique scenario.   There is a limit for corporations.

In the future, if you have a situation where you need to take capital gains, you have this capital loss to write off against those gains or you can use the $3,000 deduction the following year.

We also strongly advocate tax planning throughout the year.  Travis Brock will elaborate on this in our next newsletter.

There are specific strategies that we use to actually harvest the loss which we will do throughout the year.  If you’re incurring a loss in the books for tax purposes, this cannot hurt you. There’s no harm in this and it’s actually a benefit.  We urge our clients to engage in a healthy conversation with their tax-preparer about this topic reinforcing the fact that a loss in an account, when evaluating the total financial and tax scenarios, is actually a positive thing because you are realizing the loss (reducing your tax liability) but maintaining the asset allocation.

There are, of course, scenarios where there is a significant investment gain, but for tax purposes individuals had a realized capital loss.   In the investment world, we consider that beautiful work!  It’s also important to note:  We can’t judge how your investments are doing based solely upon how much you’re paying in taxes, your income tax return or a portfolio gain or loss.  You have to put everything into context.

Part of our job as advisors is to assist new clients who come to us with their unique financial situations.  One scenario that we see is when an investor owns a significant number of mutual funds in their taxable account and the mutual funds have large redemptions during the year (investors get spooked and sell their shares). This forces the mutual funds to pay out a substantial amount in capital gains at the end of the year.   These distributions were unwanted and unexpected by the client since they lost money on their investments and to add insult to injury, had a large tax liability! That’s the converse of what we’re talking about here.  Because they had a significant tax liability does that mean they did well?  No, they actually lost money.  That’s the ugly opposing side of it when you lose money and have to pay taxes on top of it.

Folks who work with Financial Fiduciaries, LLC have the benefit of our staff monitoring this process closely for them.  We also provide clients with online tools where they too can track their portfolio’s progress and the tax implications.

About Objectively Speaking

Tom Batterman, founder of Vigil Trust & Financial Advocacy and Financial Fiduciaries, LLC is in the business of representing the best financial interests of his clients. Having provided objective, fee-only financial management services for over two decades, he specializes in managing the investment and related financial affairs of individuals and mutual insurance companies who do not have the time, interest or expertise to manage such matters on their own. As an objective, unbiased professional who takes on a fiduciary responsibility to his clients, he guides clients to the financial decisions they would make themselves if they had years of training and experience and the time and expertise to fully research and understand all of their options. Founded in 2010 as an outgrowth of Vigil Trust & Financial Advocacy, Financial Fiduciaries, LLC is a financial management solution for individuals and mutual insurance companies who recognize they do not have the time, interest or expertise to properly attend to their financial matters on their own. While there are many financial “advisors”, most of them have investment products to sell and the “advice” they provide is geared toward getting their clients to engage in a purchase. As one of the rare subset of advisors known as “fiduciary advisors”, Financial Fiduciaries does not sell any investment product so its guidance is not compromised by conflicts of interest which plague ordinary advisors. Prior to his employment in the financial industry in financial advocacy and trust positions, he worked at a private law practice in the Wausau area in the areas of estate planning, tax, retirement planning, corporate organizations and real estate. He is a graduate of the University of Wisconsin-Madison and the UW-Madison Law School and has during his career held Series 7, 24 and 65 securities licenses. A longtime resident of the Wausau, Wisconsin Area, Tom is active in the community. He enjoys golf, curling, skiing, fishing, traveling and spending time with his family.
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