by Andrew Horowitz

At the end of every year, the term Tax Loss Selling sometimes pops up in the investment world. It is also known as Loss Harvesting.  What is this strategy and how do investors do it?  We'll cover that in this episode!

What is Tax Loss Selling?

Nobody wants losses in their portfolio. But try as we might, we can’t eliminate all losses. However, there's a little trick you can use to make the most of an investment that is underperforming instead of just taking the loss and walking away disappointed.

The practice of Tax Loss Selling is used to offset investment gains with investment losses, usually at the end of a calendar year.

Yes, it sounds so simple but many investors don't realize they have an opportunity to reduce their tax bill come April 15th by toying with a few stocks in their portfolio.

The basic strategy is to select a stock that you want to sell, or one that is grossly underperforming and sell it in order to collect the physical losses, putting them on the books as realized losses. This will reduce the tax you will be paying on sales of some of your profitable investments.

I know what it's like – we all do – we don't want to sell those underperforming stocks in our portfolio.  And what many investors do is play the "Hold and Hope" game where they just hang on to their underperforming stocks in hopes the price will rise so they won't have to realize a financial loss on the investment.  

Bad idea. As we discussed in previous episodes, it's usually a better idea to sell underperforming stocks in order to free up the capital to deploy to stocks that have a better fundamental ratio comparison and rising trend on the chart.

The concept of Tax Loss Selling can be one more reason to force yourself to dump an underperformer and redeploy the capital towards a better investment.

How Does Tax Loss Selling Work?

I don't want to wade into the weeds of discussing intricate tax concepts here, so let's just focus on the idea that when you make money on an investment, you have to pay taxes on that investment. When you make a profit, Uncle Sam must get his cut. 

However, you can reduce some of the tax by realizing a loss (aka, selling a stock that declined in value), thus losing you money.  In other words, you can achieve an offset or balance.

Let's say that last year your active trading or short-term investment activities resulted in a net gain of $20,000. If you did nothing at the end of the year, you would have to pay short-term capital gains taxes on that $20,000.

(For your reference, short-term capital gains refers to buying and selling a stock or ETF within one year of purchase.  Short-term capital gains are taxed at your ordinary income, which is higher than what you would pay for long-term capital gains, currently at 15%. Long term means you’ve held a stock for longer than a year.)

Getting back to our example – so you’ve made a profit of $20,000 last year from your investment activities. But you also bought a stock that has lost $5,000 in value. You're holding onto it in the hopes that it comes back. You can either keep holding that stock, or sell it to realize the $5,000 financial loss.  If you sell the shares and realize the loss before the end of the year, you can use that $5,000 to offset some of the profits from the $20,000 in profits on which you will pay taxes.

Doing this reduces your taxable short-term capital gains to $15,000 instead of $20,000 which results in a lower tax bill come April 15th!  That's the logic of selling an underperforming stock to offset some of your profits by taking action just before the year ends.  You should know roughly what your investment income or profits are by the end of the year, so you can make a decision of how much you want to sell to help offset some of your gains.

If you locked in a loss of $10,000 instead of $5,000, this would reduce your capital gains to $10,000 instead of $20,000.

It's also important to note that you don't want to sell a stock just to offset gains.  Prime candidates to sell include stocks that you were going to sell anyway, but were holding onto in hopes the price will rise to recapture some of your losses.  We need to sell stocks that hit our stop-losses, or otherwise change in their situation from when we decided to buy them in the first place.  This may include a series of earnings misses, reversal of trend on the chart, and so on.

Anyway, be sure to consult your accountant for additional information as needed, and be sure to read up more on this strategy before applying it.  Tax considerations are one of those areas that we need to know what we're trying to accomplish before we take any steps so we don't get caught with surprises.  

And of course consider picking up a copy of my latest book The Winning Investor's Guide to Making Money in Any Market at Amazon and other fine booksellers. In print and digital versions, too! 

Want to become a Winning Investor? Then be sure to get your copy today - The Winning Investor's Guide to Making Money in Any Market.