Planning

Silver Linings from Market Sell-Offs

Understanding Tax-Loss Harvesting

Investor and Capital Gains Tax

As the son and brother of accountants, understanding taxes is in my blood — or at least it has been the subject of many dinner conversations over my lifetime. Through these discussions, and from my work as a wealth advisor, I’ve never met anyone in my life who enjoys taxes — though we all must be reminded paying taxes is a by-product of making money. Taxes can be particularly hard to stomach in years like this one — no one wants to lose a cut of their capital gains after seeing investments across the board drop precipitously. Fortunately, in down markets, we can use active tax-loss harvesting to potentially reduce tax bills in the short- or long-term.

What is Tax-Loss Harvesting? An example: 

If you sold an investment in Apple at $600 that you originally purchased for $1,000, you would realize a loss of $400. If you also sold another investment for a $400 gain, the net result from an income tax perspective would be no reported gain. If you don’t have another realized gain to offset, you can carry forward the loss indefinitely.

The Wash Rule and Maintaining Market Exposure  

It would be too easy if we could all sell our losers to lock in the loss, and then repurchase the same security to reset our cost basis. Unfortunately, the IRS does not look favorably on this action, which is why the wash rule stipulates that you may not repurchase the same security within 30 days, or the IRS will not count the realized loss on your tax return. As an aside, the IRS does not enforce the wash sale rule on cryptocurrencies, which is why we believe selling Bitcoin for a loss and immediately repurchasing it is a smart tax move.

One of the criticisms of tax-loss harvesting strategies is that investors may miss out on potential gains as they wait out the 30 days before they can repurchase the security. Investors can avoid triggering the wash rule and maintain desired market exposure by purchasing investments similar to — but not the same as — the ones sold. This could look like selling Coca Cola (KO) and purchasing PepsiCo (PEP) to maintain exposure to global snacks and beverages or selling the SPDR S&P 500 ETF (SPY) and purchasing the iShares Russell 1000 ETF (IWB) to maintain exposure to U.S. Large Cap Stocks.

Our Custom Approach for Clients  

At Balentine, we take this a step further when appropriate by using separately managed accounts (SMAs) to create custom indices aligning to our desired exposures. This gives those clients the broad market exposure of an ETF and the flexibility to tax-loss harvest at the individual stock level. For example, in 2021, the S&P 500 ended the year up 27%. If you had purchased SPY, an ETF that tracks the index, at the start of the year, you would not have had an opportunity to realize any losses since the maximum drawdown was only 1.4%. However, if you had purchased a basket of stocks to replicate the S&P 500, you would have had plenty of opportunities at the security level — during 2021, 208 of the stocks in the S&P 500 fell by more than 8%, while 305 fell more than 5%.

Separately managed accounts also allow us to trade in a more tax-efficient manner. Last year we realized a highly profitable and long-term trade, shifting from U.S. Large Cap Growth to U.S. Large Cap Value in client portfolios using ETFs. Under the surface, however, there was overlap between the underlying holdings that we could not avoid selling and repurchasing. For example, the S&P 500 consists of 504 stocks (yes, I know this is shocking) at a variety of allocation weights based on market cap. The S&P 500 Growth index consists of 240 names, while the S&P 500 Value index consists of 447 names, meaning 183 stocks are found in both indices. When you sell one ETF to go into the other, you’ve effectively sold and repurchased 183 stocks! Now that we’ve added the SMA capabilities to create our own custom indices, we would simply sell the portion of Growth not held by Value, realizing gains in a smaller number of holdings.

Conclusion 
Market downturns can be scary, yet they present opportunities to reduce one’s tax bill in current years and into the future. Should you have further questions about how this relates to your personal financial situation, please reach out to your relationship manager.

Contact Us

Looking for guidance managing your wealth? Balentine is committed to providing the education and advice our clients need to realize their goals.