When can the loss of tax losses backfire?

Tax Loss Harvesting: Should Investors Believe the Hype?

Do Tax Loss Harvesting Strategies Increase After-Tax Returns?

Many hypothetical, back-tested performance claims imply this - and by far. However, consultants should think twice before using these claims to set client expectations. The added value of such strategies depends on the future market environment and the circumstances of an investor.

Andrew L. Berkin and Jia Ye, in Tax Management, Loss Harvesting, and HIFO Accounting, highlight how market environments, portfolio cash flows, and tax rates influence the effectiveness of tax loss harvesting strategies. They conclude that markets with higher stock-specific risks and lower average returns provide the most fertile ground for such strategies. They also show that a steady stream of contributions reinvigorates a portfolio and helps maintain the benefits of harvesting tax losses over time. On the flip side, large withdrawals are counterproductive for such strategies, while the benefits are usually roughly linearly related to an investor's tax rate.

These results suggest that the potential benefits of harvesting tax losses depend on an investor's financial situation and must be weighed against the risks.

Harvesting a loss can result in tax savings today, but it lowers the cost base of the investment and can increase future tax liability. If the investor's tax rate increases in the future, the tax deferral benefit of the loss harvested could decrease. Conversely, if the tax rate falls, the deferral benefit could be increased.

Many pro tax loss harvesting studies assume that the investor's tax rate will remain stable over time. That is often unrealistic. Interest rates can change drastically due to changes in policy or life events. Current federal income tax rates in the US are expected to expire after 2025, which can mean higher marginal tax rates. Jason Zweig shows how crop losses can backfire if tax rates rise in the future. The Trump administration is reportedly considering a tax cut on investment income. Christine Benz argues that investors in lower tax brackets want temporary gains, not losses.

The trading required to implement these strategies also carries risks. By helping an investor realize the economic benefits of a loss without significantly altering the risk / reward characteristics of their portfolio, harvesting tax losses can be contrary to tax law. Under the IRS laundering sale rule, if an investor purchases the same security or a security that is "substantially identical" at a loss within 30 days of the sale or within 30 days of the sale, the loss is prohibited. Consultants seek to circumvent the laundromatic sale rule by "swapping taxes" or selling securities at a loss and using the proceeds to purchase similar but not "substantially identical" securities.

Tax swap is not perfect: it exposes investors to the risk that the new security will lag behind the security sold at a loss, which could negate the expected economic benefits of the trade.

A warning about hypotheses

Many tax loss harvest strategies ads contain hypothetical back tests that are loaded with very specific assumptions. These back tests are cherry pick scenarios: the investor can be heavily weighted in volatile assets, in the highest tax brackets, make consistent portfolio contributions, have little need for liquidity or be exposed to a large bear market at the beginning of the evaluation period. In many cases, such circumstances are incorrect and can produce results that set investor expectations too high.

Backtest results can also lead an investor to underestimate the risks. For example, it is much easier, in retrospect, to determine when to sell assets at a loss and to instantly identify securities that reflect their future performance.

There is nothing inherently wrong with images that contain back-tested performance data. When they meet certain standards, they can help investors understand how a recommended strategy may play out under certain conditions. However, advisors should always consider the number of disclosures required - and the sophistication of the audience. Ads promoting the backtesting performance of tax loss harvest strategies are often complex and require loads of fine print. Most retail investors are not smart enough to sort all “what ifs”.

Conclusion

Tax-efficient portfolio management cannot take place in a vacuum. It requires adjustment and regular communication, as well as input from an investor's tax advisor. Investors in high tax brackets can take advantage of long-term losses to offset short-term capital gains and decent income, or defer capital gains indefinitely, which could be good candidates for tax losses. But those in lower tax brackets with shorter time horizons may have less to gain. Of course, these scenarios are also generalizations and should be viewed with other factors and risks.

It is not safe to say that harvesting tax losses will significantly increase the after-tax return without knowing very precise details about the investor's financial situation. Such strategies should never be bottled and sold to the masses as turnkey trading systems. Advisors and investors should be wary of any promotions claiming that a tax loss harvest strategy will improve a portfolio's after-tax return by a certain amount.

What is your view of strategies for harvesting tax losses and how are these being sold to private investors? Let us know in the comments below.

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All contributions are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of the CFA Institute or the author's employer

Photo credit: © Getty Images / z_wei

David Allison, CFA, CIPM

David L. Allison, CFA, CIPM, is vice president and founding partner of Allison Investment Management, LLC. He has formal training in investment analysis, portfolio management, and techniques for measuring investment performance. He has extensive experience managing investment portfolios for high net worth investors. Allison is an active member of the CFA Institute and the CFA Society of South Carolina, where he is a past president and currently serves on the board of directors. He holds a degree in finance from the University of North Carolina at Wilmington. Advised by Allison Investment Management, LLC. Securities offered through Triad Advisors, LLC. Member of FINRA & SIPC. Allison Investment Management, LLC is a registered investment advisor and is not affiliated with Triad Advisors, LLC.