Your Investment Portfolio Is Down Big This Year? This Is How You Recover Some of Your Losses
*The following article pertains to United States tax policy. If you live outside of the U.S. please consult your local tax code*
For newer investors who entered the stock or cryptocurrency markets over the past two years, it may have been stomach churning to watch your portfolio drop 50, 60, 80% or more in value from all-time highs. There have been few safe havens in this bear market as even the S&P 500 is down 21.32% year to date.
The good news is that using the right strategies makes the stock market somewhat risk free, especially for investors who have invested smaller amounts.
The strategy is what is called tax loss harvesting. Many people are aware of this, but it is good to remind others that time is running out to recover some of your losses
Similar to how you are required to pay taxes on any gains made on your investments, the IRS allows you to deduct any investment losses from the taxes you owe the following year up to $3,000.
For instance, if you bought shares of a stock for $1,000 and your investment dropped 70% to $300, you can sell the stock to realize a $700 loss. The $700 loss is deducted from or offsets the taxes that you may owe on the capital gains from any profitable investments you sold during the year.
You still have $300 from the sale of the stock, and you can even buy back the stock after a short period of time if you still have conviction in the business. This works for any tradable security (stocks, bonds, ETFs, cryptocurrency, etc.).
You can repeat this process for the depreciated assets in your portfolio up to a $3,000 tax write off. If you exceed $3,000 in realized losses, then you can even carry over excess losses for tax deductions in future years.
If you bought $1,000 of another stock at some point that doubled in value to $2,000 and sold the investment this year, then you realized a $1,000 gain. You can deduct the $700 loss in the earlier example from the $1,000 gain to only pay taxes on $300 instead of $1,000.
If you don't have any capital gains from any stocks you sold for profit, which is understandable considering the sort of year it has been, or your realized loss exceeds your realized gains in the stock market, then any realized investment loss or net loss lowers your taxable income for the year.
For instance, if you reached the $3,000 deductible limit in realized losses or net losses, and you made $60,000 this year, then the $3,000 loss or net loss would lower your taxable income to $57,000. Hypothetically, if your marginal income tax rate is 25%, then you would save yourself $750 in taxes.
This year, possibly more than any year in recent memory, it is crucial to take advantage of this tax loss harvesting strategy.
During the Federal Open Market Committee meeting on 11/2/2022, the Federal Reserve chairman, Jerome Powell, made very hawkish, unequivocal statements that the Federal Reserve will continue to increase federal interest rates into the future, and the terminal federal interest rate may be higher than previously expected. Analyzing Consumer Price Index (CPI) data reports from the past several months, record high inflation is stubbornly persistent and is even increasing in some facets of the economy.
As peak inflation rates remain elevated and uncontrolled, Powell has made comments that the Fed is prepared to force a recession through its interest rate hikes.
High federal interest rates make it harder or more expensive for businesses to raise capital in order to expand operations, and consumer debt becomes more expensive. Companies’ growth stalls as inflation eats into gross margins and interest on debt increases. High inflation, unemployment, and expensive consumer debt decimates consumers’ disposable income. and consumer demand for goods and services plunges. Many analysts forecast a deep recession going into 2023 if we are not in one already.
The biggest risk to tax loss harvesting is that it is essentially a bet against the stock market prices appreciating in value in the short term; you are betting after selling stocks and realizing a loss that stock prices will remain at their current prices or lower in the future. This is a major risk in a bull stock market or in a healthy economy, but today, that risk is very much mitigated. Especially after the recent Federal Open Market Committee meeting, the trend seems to be that stocks prices will continue to fall in the near term until the economy bottoms from a macroeconomic perspective. Some stock prices may be close to bottoming out, but fundamentally, many stocks will continue to decline in value as the inevitable recession deepens. Even stocks already at rock bottom prices may not rebound until inflation and interest rate hikes ease. In the history of the stock market, the market has never entered a sustained bull market while the Federal Reserve was raising interest rates, or during a quantitative tightening cycle. The same may be said for cryptocurrency, which has been correlated to the stock market this past year.
This leads to the most important rule when utilizing tax loss harvesting--the wash sale rule. Simply, to benefit from the tax benefits of realized investment losses, you cannot buy the same or substantially identical asset(s) 30 days before selling it, and you cannot repurchase the same asset(s) for 30 days from the date you sold the asset and realized the loss. This is a 61-day window--before, after, and including the sell date--that you cannot purchase the identical investment. Violating this rule will not allow you to claim any tax benefit for the realized loss of a stock, cryptocurrency, exchange traded fund, bond, etc. This wash sale rule, unfortunately, includes any options trading. Once this 61-day window has passed, you can buy back into the same stock or asset if you still have conviction in it, or use the opportunity to reinvest elsewhere and reallocate your portfolio.
Many people get around this wash sale rule by purchasing a similar but not identical investment so that they maintain exposure to the industry during this wash sale window. For instance, if you were to sell Tesla stock to realize a loss to lower your tax bill, then perhaps you buy an electric vehicle ETF or another electric vehicle stock. This would protect you in case the electric vehicle industry or overall stock market prices appreciate in value during these 61 days.
It is important to note that the wash sale rule does not apply to cryptocurrency as of now. The rule only applies to stocks, securities, and other traditional financial assets that are traded on regulated exchanges. Since cryptocurrency is largely unregulated, it is not considered a “security,” so crypto escapes the wash sale rule. In theory, you could sell your cryptocurrency to realize a loss for tax benefits and repurchase the same cryptocurrency immediately without losing exposure to the crypto. This makes cryptocurrency the perfect asset to lower your tax bill with little to no downside. Take advantage of this loophole while you can; most likely, the U.S. government will pass legislation to apply the wash sale to cryptocurrency in the future.
We have seen bull market rallies within bear markets where the stock market prices have skyrocketed 10% to 20% over the last one or two years. However, these rallies have always been short lived and the markets eventually plunged to previous or new lows. Even if one of these rallies occur during your “wash-sale” window, it is unlikely that the price of these assets will exceed your cost basis, or the price you paid for the stock or cryptocurrency, from 2021 or early 2022 given how much many of these asset prices are down from their all-time highs. For instance, if a stock that you purchased is 75% down from when you purchased it in 2021, it would need to quadruple for you to break even. Repurchasing the investment 30 days after your sell date will most likely not make you worse off than before.
With a deeper global recession looming, it is imperative now more than ever that investors understand tax loss harvesting given the economic environment we are in. It is possible to invest for the long-term while still taking advantage of mitigating your losses in the short-term, especially if you expect to owe taxes next year.
This is a unique situation this year compared to previous years where the benefits of tax loss harvesting may outweigh the risks considering that we can expect many stock prices to trend lower over the next months or years. You have until December 31st of this year to realize any investment losses for filing your taxes in early 2023. Investors who are sitting on large unrealized losses in their portfolios may want to consider capitalizing on these market conditions before time runs out.
*You should consider your individual financial situation when making any decisions regarding your taxes. If you are unsure, please conduct your own due diligence or consult a certified tax professional*