Tag Archives: Tax Loss Harvesting

2023 Year-End Tax Planning

It’s that time of year again. The air is crisp and my favorite football team is surging. That can only mean one thing when it comes to personal finance: time to start thinking about year-end tax planning.

I’ll break it down with three categories: Urgent, Year-End Deadline, and Can Wait Till Next Year. I will also provide some thoughts on 2024 tax planning that can/should be done before year-end in 2023.

As always, none of this is advice for your particular situation but rather it is educational information. 

Urgent

By urgent, I mean those items that (i) need to happen before year-end and (ii) may not happen if taxpayers delay and try to accomplish them late in the year. 

Donor Advised Fund Contributions

The donor advised fund is a great way to contribute to charity and accelerate a tax deduction. My favorite way to use the donor advised fund is to contribute appreciated stock directly to the donor advised fund. This gets the donor three tax benefits:

  1. A tax deduction for the fair market value of the contributed appreciated stock,
  2. Elimination of the built-in capital gain on the contributed appreciated stock, and
  3. Tax-free treatment of the income earned inside the donor advised fund.

In order to get the first benefit in 2023, the appreciated stock must be received by the donor advised fund prior to January 1, 2024. This deadline is no different than the normal charitable contribution deadline.

However, due to much year end interest in donor advised fund contributions and processing time, different financial institutions will have different deadlines on when transfers must be initiated in order to count for 2023. Donor advised fund planning should be attended to sooner rather than later. 

Taxable Roth Conversions

For a Roth conversion to count as being for 2023, it must be done before January 1, 2024. That means New Year’s Eve is the deadline. However, taxable Roth conversions should be done well before New Year’s Eve because 

  1. It requires analysis to determine if a taxable Roth conversion is advantageous, 
  2. If advantageous, the proper amount to convert must be estimated, and 
  3. The financial institution needs time to execute the Roth conversion so it counts as having occurred in 2023. 

Remember, generally speaking it is not good to have federal and/or state income taxes withheld when doing Roth conversions!

Roth Conversion Example: See slides 8 through 10 of this slide deck for an example of a Roth conversion in retirement. You might be surprised by just how little federal income tax is owed on a $23,000 Roth conversion.

Example Where I Disfavor Roth Conversions: I present an example of a 73-year old married couple with $400K in deferred retirement accounts and $87K in 2023 gross income. I would not recommend they do end-of-year Roth conversions. This spreadsheet computes the taxable Social Security with and without a $10K Roth conversion.

Gotta Happen Before 2026!!!

You will hear many commentators say “do more Roth conversions before tax rates go up in 2026!” If this were X (the artist formerly known as Twitter), the assertion would likely be accompanied by a hair-on-fire GIF. 😉

I disagree with the assertion. As I have stated before, there’s nothing more permanent than a temporary tax cut. You do your own risk assessment, but mine is this: members of Congress like to win reelection, and they are not going to want to face voters without having acted to ensure popular tax cuts, such as the reduction of the 15% tax rate down to 12% and the increased standard deduction, are extended. 

I recommend that you make your own personal taxable Roth conversion decisions based on your own personal situation and analysis of the landscape and not a fear of future tax hikes.

Learn all about the Pro-Rata Rule here.

Adjust Withholding

This varies, but it is a good idea to look at how much tax you owed last year (line 24 on the Form 1040). If you are on pace to get 100% (110% if 2022 AGI is $150K or greater) or slightly more of that amount paid into Uncle Sam by the end of the year (take a look at your most recent pay stub), there’s likely no need for action. But what if you are likely to have much more or much less than 100%/110%? It may be that you want to reduce or increase your workplace withholdings for the rest of 2023. If you do, don’t forget to reassess your workplace withholdings for 2024 early in the year. 

Backdoor Roth IRA Diligence

The deadline for the Backdoor Roth IRA for 2023 is not December 31st, as I will discuss below. But if you have already completed a Backdoor Roth IRA for 2023, the deadline to get to a zero balance in all traditional IRAs, SEP IRAs, and SIMPLE IRAs is December 31, 2023. 

Solo 401(k) Planning

There’s plenty of planning that needs to be done for solopreneurs in terms of retirement account contributions. Even though Schedule C solopreneurs can now establish a Solo 401(k) after year-end (up to April 15th), it is absolutely the case that it is better to do the planning upfront. For those Schedule C solopreneurs with a Solo 401(k) established, December 31st is the deadline to make 2023 employee deferral contributions or make a 2023 deferral election as an alternative to making the payments in 2023. December 31st is also the 2023 employee deferral contribution for solopreneurs operating out of S corporations.

The Solo 401(k) can get complicated. That’s why I wrote a book about them and post an annual update on Solo 401(k)s here on the blog. 

Year-End Deadline

These items can wait till close to year-end, though you don’t want to find yourself doing them on New Year’s Eve.

Tax Gain Harvesting

For those finding themselves in the 12% or lower federal marginal income tax bracket and with an asset in a taxable account with a built-in gain, tax gain harvesting prior to December 31, 2023 may be a good tax tactic to increase basis without incurring additional federal income tax. Remember, though, the gain itself increases one’s taxable income, making it harder to stay within the 12% or lower marginal income tax bracket. 

I’m also quite fond of tax gain harvesting that reallocates one’s portfolio in a tax efficient manner. 

Tax Gain Harvesting Example: See slide 15 of this slide deck for an example of tax gain harvesting in retirement.

Tax Loss Harvesting

The deadline for tax loss harvesting for 2023 is December 31, 2023. Just remember to navigate the wash sale rule. 

RMDs from Your Own Retirement Account

The deadline to take any required minimum distributions from one’s own retirement account is December 31, 2023. Remember, the rules can get a bit confusing. Generally, IRAs can be aggregated for RMD purposes, but 401(k)s cannot. 

RMDs from Inherited Accounts

The deadline to take any RMDs from inherited retirement accounts is December 31st. For some beneficiaries of retirement accounts inherited during 2020, 2021, and 2022, the IRS has waived 2023 RMDs. That said, all beneficiaries of inherited retirement accounts may want to consider affirmatively taking distributions (in addition to RMDs, if any) before the end of 2023 to put the income into a lower tax year, if 2023 happens to be a lower taxable income year vis-a-vis future tax years. 

Can Wait Till Next Year

Traditional IRA and Roth IRA Contribution Deadline

The deadline for funding either or both a traditional IRA and a Roth IRA for 2023 is April 15, 2024. 

Backdoor Roth IRA Deadline

There’s no law saying “the deadline for the Backdoor Roth IRA is DATE X.” However, the deadline to make a nondeductible traditional IRA contribution for the 2023 tax year is April 15, 2024. Those doing the Backdoor Roth IRA for 2023 and doing the Roth conversion step in 2024 may want to consider the unique tax filing when that happens (what I refer to as a “Split-Year Backdoor Roth IRA”). 

HSA Funding Deadline

The deadline to fund an HSA for 2023 is April 15, 2024. Those who have not maximized their HSA through payroll deductions during the year may want to look into establishing payroll withholding for their HSA so as to take advantage of the payroll tax break available when HSAs are funded through payroll. 

The deadline for those age 55 and older to fund a Baby HSA for 2023 is April 15, 2024. 

2024 Tax Planning at the End of 2023

HDHP and HSA Open Enrollment

It’s open enrollment season. Now is a great time to assess whether a high deductible health plan (a HDHP) is a good medical insurance plan for you. One of the benefits of the HDHP is the health savings account (an HSA).

For those who already have a HDHP, now is a good time to review payroll withholding into the HSA. Many HSA owners will want to max this out through payroll deductions so as to qualify to reduce both income taxes and payroll taxes.

Self-Employment Tax Planning

Year-end is a great time for solopreneurs, particularly newer solopreneurs, to assess their business structure and retirement plans. Perhaps 2024 is the year to open a Solo 401(k). Perhaps their business is growing such that an S corporation election makes sense. The best time to be thinking about these sorts of things for 2024 is late in 2023. Often this analysis benefits from professional consultations.

Additional Resource

Please see my November 11, 2023 ChooseFI Orange County year-end tax planning presentation slide deck.

FI Tax Guy can be your financial planner! Find out more by visiting mullaneyfinancial.com

Follow me on Twitter at @SeanMoneyandTax

This post is for entertainment and educational purposes only. It does not constitute accounting, financial, legal, investment, or tax advice. Please consult with your advisor(s) regarding your personal accounting, financial, legal, investment, and tax matters. Please also refer to the Disclaimer & Warning section found here.

2022 Year-End Tax Planning

Below are the main tax planning items for the year 2022 as I see them. Of course, this is educational information for the reader, and not tax advice directed toward any particular individual. 

The first two tax loss harvesting items are particularly unique to 2022 vis-a-vis recent years. 

Tax Loss Harvesting

2022 has given us plenty of lemons. For some Americans, it’s time to make some lemonade through tax loss harvesting. The deadline to do this and obtain a benefit on one’s 2022 tax return is December 31, 2022. 

Tax Loss Harvesting and Bonds

There is a tax loss harvesting opportunity in 2022 that has not existed in recent years to the scope and scale it exists today: tax loss harvesting with bonds and bond funds. In a recent post I went into that opportunity in detail and how it might create both a great tax loss harvesting opportunity and a great tax basketing opportunity. 

Tax Loss Harvesting Crypto

Many cryptocurrencies have declined in value. This can create a tax loss harvesting opportunity, regardless of whether the taxpayer wants to remain invested in crypto. To harvest the loss if one wants to get out of crypto, it’s easy: just sell the asset. For those wanting to stay in crypto, it’s not that much harder: sell the crypto (by December 31, 2022 if wanting the loss on their 2022 tax return) and they rebuy the crypto shortly thereafter. Crypto is not a “security” for wash sale purposes, and thus, repurchases of crypto are not subject to the wash sale rule, regardless of when they occur. 

Solo 401(k) Establishment

Quick Update 12/23/2022: My initial reading of SECURE 2.0 is that it does not change any 2022 Solo 401(k) deadlines. The one deadline it appears to change is effective starting for plan years beginning in 2023.

For Schedule C solopreneurs looking to make a 2022 employee contribution to a Solo 401(k), the Solo 401(k) must be established by December 31, 2022. This is NOT the sort of thing you want to try to do on December 30th. Almost certainly those trying to establish a Solo 401(k) will want to act well before the end of December, as it takes time to get the Solo 401(k) established prior to year-end. 

The deadline to establish a Solo 401(k) for an employer contribution is the tax return filing deadline. For individuals, this is April 18, 2023, but can be extended to October 15, 2023. For S corporations, this is March 15, 2023, but can be extended to September 15, 2023. 

Solo 401(k) Funding for Schedule C Solopreneurs

Employee elective deferral contributions (traditional and/or Roth) must meet one of two standards. Either (i) they must be made by December 31st or (ii) they are elected by December 31st and made by the tax return filing deadline, including any filed extensions. 

Employer contributions must be made by the tax return filing deadline, including any filed extensions. 

Roth Conversions 

Taxpayers with lower income (relative to the rest of their lives) may want to consider taxable conversions of traditional retirement accounts to Roth accounts. The deadline to get the Roth conversion on one’s 2022 tax return is December 31st, though it is not wise to wait until the last minute.

For the self-employed, there may be a unique opportunity to use Roth conversions to optimize the qualified business income deduction. 

Tax Gain Harvesting

For those finding themselves in the 12% or lower federal marginal income tax bracket and with an asset in a taxable account with a built-in gain, tax gain harvesting prior to December 31, 2022 may be a good tax tactic to increase basis without incurring additional federal income tax. Remember, though, the gain itself increases one’s taxable income, making it harder to stay within the 12% or lower marginal income tax bracket. 

HSA Funding Deadline

The deadline to fund an HSA for 2022 is April 18, 2023. Those who have not maximized their HSA through payroll deductions during the year may want to look into establishing payroll withholding for their HSA so as to take advantage of the payroll tax break available when HSAs are funded through payroll. 

The deadline for those age 55 and older to fund a Baby HSA for 2022 is April 18, 2023. 

Roth IRA Contribution Deadline

The deadline for funding a Roth IRA for 2022 is April 18, 2023. 

Backdoor Roth IRA

There’s no law saying “the deadline for the Backdoor Roth IRA is DATE X.” However, the deadline to make a nondeductible traditional IRA contribution for the 2022 tax year is April 18, 2023. Those doing the Backdoor Roth IRA for 2022 and doing the Roth conversion step in 2023 may want to consider the unique tax filing when that happens (what I refer to as a “Split-Year Backdoor Roth IRA”). 

Anyone who has already completed a Backdoor Roth IRA for 2022 should consider New Year’s Eve. December 31st is the deadline to be “clean” for 2022. Anyone who has done the Roth conversion step of a Backdoor Roth IRA during 2022 will want to consider (to the extent possible and desirable)  “cleaning up” all traditional IRAs, SEP IRAs, and SIMPLE IRAs as of December 31, 2022. 

Charitable Contributions

The deadline to make charitable contributions that can potentially be deducted on one’s 2022 tax return is December 31, 2022. Planning in this regard could include contributions to donor advised funds. If one is considering establishing a donor advised fund to get a deduction in 2022, I recommend moving well before December 31st, since it takes time for financial institutions to process donations and establish donor advised funds. 

RMDs from Your Own Retirement Account

The deadline to take any required minimum distributions from one’s own retirement account is December 31, 2022. Remember, the rules can get a bit confusing. Generally, IRAs can be aggregated for RMD purposes, but 401(k)s cannot. 

RMDs from Inherited Accounts

The deadline to take any RMDs from inherited retirement accounts is December 31st. For some beneficiaries of retirement accounts inherited during 2020 and 2021, the IRS has waived 2022 RMDs. That said, all beneficiaries of inherited retirement accounts may want to consider affirmatively taking distributions (in addition to RMDs, if any) before the end of 2022 to put the income into a lower tax year, if 2022 happens to be a lower taxable income year vis-a-vis future tax years. 

FI Tax Guy can be your financial planner! Find out more by visiting mullaneyfinancial.com

Follow me on Twitter at @SeanMoneyandTax

This post is for entertainment and educational purposes only. It does not constitute accounting, financial, legal, investment, or tax advice. Please consult with your advisor(s) regarding your personal accounting, financial, legal, investment, and tax matters. Please also refer to the Disclaimer & Warning section found here.

The Special Tax Loss Harvesting Opportunity for 2022

There is a tax loss harvesting opportunity in 2022 that has not existed in recent years to the scope and scale it exists today: tax loss harvesting with bonds and bond funds. In most recent years, many bonds and bond funds have not had significant built-in-losses. 2022 is different: now there are plenty of bonds and bond funds in taxable accounts with significant built-in-losses. 

Tax Basketing for Bonds and Bond Funds

Bonds tend to be tax inefficient, for two reasons. First, they generate ordinary income, which is taxed at the taxpayer’s highest marginal tax rate. Second, they tend to have higher yields than equity investments. Thus, a dollar of a bond fund often produces more taxable income than a dollar of an equity fund, if they are both owned inside a taxable account.

As a result, holding bonds and bond funds in traditional retirement accounts is often logical from a tax basketing (or tax location) perspective. If they produce ordinary income anyways, why not hold them in a traditional retirement account (IRA, 401(k), etc.) where the owner can defer the timing of the ordinary income taxable event (through later Roth conversions and/or distributions)? 

Tax Basketing for Stocks and Equity Funds

Bonds also don’t suffer from the “transmutation” problem equities have. Stocks and equity funds, in most cases, pay “qualified dividend income” which qualifies for the lower long term capital gains tax rates (including the 0% long term capital gains tax rate). Holding them in a traditional retirement account transmutes that preferred income into ordinary income, subject to the taxpayer’s marginal ordinary tax rate. 

Now, as a practical matter, most Americans have most of their non-real estate financial wealth in traditional retirement accounts. Having some equities in traditional retirement accounts should not in any way cause despair. But, on the margins, it can be beneficial to review the overall portfolio to see if there can be some tax efficiency gains made by some tax rebasketing of assets. 

Rebasketing and Tax Loss Harvesting

The deadline for tax loss harvesting for 2022 is December 31, 2022. 

To my mind, some of the best 2022 tax loss harvesting will be selling bonds and bond funds at a loss in taxable accounts. Why is that? Because this sort of tax loss harvesting enjoys the main benefits of tax loss harvesting and it can achieve a great tax basketing result. 

Bonds create ordinary income and are generally higher yielding than equities, which often produce tax favored qualified dividend income. Thus, from a tax basketing or tax location perspective, it can often make sense to hold bonds and bond funds in a traditional retirement account and hold equities in a taxable account. Today, many investors can do some tax loss harvesting and strategically reconfigure their portfolios to make them much more tax efficient. Here is an example of how this could play out.

Jorge is 30 years old. He currently owns a diversified equity fund (Fund A) inside his workplace traditional 401(k) plan worth $80,000. It has a 2% annual dividend yield, most of which is qualified dividend income (though of course it is tax deferred inside the 401(k) and will later be subject to ordinary income tax when withdrawn or Roth converted). Separately, he owns a diversified bond fund (Fund B) inside his taxable brokerage account. It is worth $20,000, and Jorge has a $24,000 tax basis in the fund. The bond fund has a 3% annual interest yield ($600), all of which is ordinary income. Jorge wants to have an 80% / 20% equity to bond allocation. 

Here’s Jorge’s portfolio today:

AssetAmountAnnual Taxable Income
401(k) Fund A (Equity)$80,000None
Taxable Fund B (Bond)$20,000$600
Total$100,000$600

Jorge, could, in theory, execute two transactions to both tax loss harvest and become more tax efficient from a tax basketing perspective. First, Jorge could exchange his $20K of Fund B for $20K of an equity fund inside his brokerage account with a dividend yield similar to Fund A. Second, inside his 401(k), he could exchange $20K worth of his Fund A holding for a bond fund with an income yield similar to Fund B. If Jorge’s new fund inside the 401(k) is not substantially identical to Fund B, he can claim most, if not all, of the $4,000 loss, though the prior month’s Fund B dividend might slightly reduce the loss under the wash sale rule.

Here’s Jorge’s portfolio after these two transactions:

AssetAmountAnnual Taxable Income
401(k) Fund A (Equity)$60,000None
401(k) Bond Fund$20,000None
Taxable Equity Fund$20,000$400
Total$100,000$400

Jorge may obtain two tax benefits from these transactions. First, assuming he successfully navigates the wash sale rule, he may be able to deduct up to $3,000 against ordinary income by triggering the capital loss on the Fund B sale. 

Second, regardless of whether he successfully navigated the wash sale rule, he has just made his portfolio more tax efficient. It used to be that he reported $600 of ordinary income (from Fund B) on his tax return. Now that sort of interest income is hidden inside the 401(k). If he now receives approximately $400 a year in qualified dividend income from the new equity fund inside the taxable brokerage account, he has (i) reduced his annual taxable income by $200 (and growing through compounding) and (ii) now has mostly qualified dividend income from the taxable account instead of ordinary income, lowering his federal tax rate on his portfolio income. He has done all that without disturbing his overall asset allocation. 

Getting the tax basketing of his investments better without changing his investment allocation is likely to be worth it even if loses the tax loss due to the wash sale rule. He would want to review the options available to him inside his 401(k) to see if there is an acceptable (to him) bond fund that is not “substantially identical” to Fund B so as to avoid the wash sale rule being triggered by the investment in a bond fund inside the 401(k). 

Conclusion

Declines in the stock and bond market are some of the lemons of 2022. But, there’s a chance to make some lemonade. When it comes to bonds held in taxable accounts, there may be an opportunity to obtain two benefits: tax loss harvesting and better tax basketing. 

FI Tax Guy can be your financial planner! Find out more by visiting mullaneyfinancial.com

Follow me on Twitter at @SeanMoneyandTax

This post is for entertainment and educational purposes only. It does not constitute accounting, financial, legal, investment, or tax advice. Please consult with your advisor(s) regarding your personal accounting, financial, legal, and tax matters. Please also refer to the Disclaimer & Warning section found here.

The Mystery of the Disappearing Tax Basis

Tax loss harvesting is all the rage in a down stock market. Did you know that it can create a mystery worthy of the Hardy Boys? Read on to find out how tax basis can disappear because of tax loss harvesting and the wash sale rule. 

Tax Loss Harvesting

I’ve previously written about tax loss harvesting. The idea is to sell a stock, bond, mutual fund, ETF, or other asset at a loss and report that loss on a tax return. That loss can offset other capital gains, and after having done that, it can offset ordinary income (W-2 income, interest income, etc.) up to $3,000 per year. Unused capital losses can be carried forward to subsequent tax returns indefinitely.

Tax loss harvesting is a nice tactic and in the right circumstances can be beneficial. That said, tax loss harvesting should not be a primary driver of one’s investment portfolio allocation. 

The Wash Sale Rule

The opportunity presented by tax loss harvesting has a major hurdle: the wash sale rule. Any acquisition of the same asset or a “substantially identical” asset 30 days before or 30 days after the sale at a loss denies the loss on the tax return. This is a very logical rule, considering the potential for abuse. Here’s an example:

Example 1: Sal owns 30 shares of Acme Corporation stock. He purchased it for $200 per share, and it is now worth $140 per share. Without the wash sale rule, Sal could sell all 30 shares for $140 on December 1st (triggering a $1,800 loss on his tax return) and then purchase 30 shares of Acme Corporation on December 2nd for its current value and have very little change in his economic position. 

Seen through the lens of Sal’s example, the wash sale rule makes sense. Why should Sal get to claim a loss on 30 shares of Acme stock he owns at year-end?

However, the wash sale rule can be implicated in less clear cut situations. Here’s one example:

Example 2: Cate owns 500 shares of IBM stock* in her taxable brokerage account. She purchased each share for $150 per share. On July 6, 2022, she sold 300 shares for $140 per share, realizing a $3,000 capital loss (300 times $10 loss per share). On July 29, 2022, IBM paid a dividend of $3 per share ($600 total on Cate’s remaining 200 shares), which Cate automatically reinvested in IBM stock, now valued again at $150 per share. 

In Cate’s case, the dividend reinvestment purchased 4 shares of IBM stock within the 61-day wash sale window. The taxable loss on 4 shares of the 300 sold ($40 total) is disallowed by the wash sale rule, and Cate will only be able to claim a taxable loss of $2,960 on the July 6th sale. 

* All values used in this blog post are hypothetical for purposes of the example. I did not look up IBM’s actual stock prices on these dates. The IBM dividend is also made up for the sake of the example.

One interesting tidbit about the wash sale rule in today’s environment: as the rule only applies to “securities” it does not apply to cryptocurrencies. Thus, an investor can sell a cryptocurrency at a loss on one day and repurchase it a day later and claim the entire loss on his or her tax return. There are proposals to do away with this treatment and subject cryptocurrencies to the wash sale rule. 

Retirement Accounts and the Wash Sale Rule

Let’s change Cate’s example just a bit, by having the repurchase occurring inside a Roth IRA.

Example 3: Cate owns 300 shares of IBM stock in her taxable brokerage account. She purchased each share for $150 per share. On July 6, 2022, she sold all 300 shares for $140 per share, realizing a $3,000 capital loss (300 times $10 loss per share). Separately, Cate owns 200 shares of IBM in her Roth IRA. On July 29, 2022, IBM paid a dividend of $3 per share ($600 total on Cate’s remaining 200 shares), which Cate’s Roth IRA automatically reinvested in IBM stock, now valued again at $150 per share. 

What result? The IRS has issued a Revenue Ruling, Rev. Rul. 2008-5, ruling that if the repurchase occurs inside the taxpayer’s Roth IRA or traditional IRA, the wash sale rule applies. Cate would suffer the exact same $40 wash sale rule loss disallowance. 

Note that a Revenue Ruling is not binding on taxpayers and the courts. Of course, a judge or appellate court may agree with the conclusion the IRS reaches in a Revenue Ruling, but they are not obligated to do so based solely on the IRS having issued the ruling. Rev. Rul. 2008-5 cites two 1930s court cases as authority for the conclusion reached in the ruling. Those cases involve a taxpayer using a controlled corporation to attempt to get around the wash sale rule, and the courts ruled that the wash sale rule applied regardless. 

In my research, I have not found any published court cases which have weighed in on Rev. Rul. 2008-5. The wash sale rule, as found in Section 1091, does not explicitly deem a retirement account and its owner to be the same person. Thus, there is at least some (perhaps quite small) risk to the IRS that a court would deem the primary result in Rev. Rul. 2008-5 to be too much of a stretch. That said, I certainly would not recommend taking a position counter to the ruling. I would struggle to advise that the wash sale rule does not apply if the security is repurchased in a retirement account. 

Disappearing Basis?

The wash sale rule disallows a loss, but it does not disallow basis. Section 1091(d) of the Internal Revenue Code and Treasury Regulation Section 1.1091-2 provide for a tax basis adjustment so that taxpayers are ultimately made whole after the application of the wash sale rule. Broadly speaking, the tax rules allow the disallowed loss to be added to the basis of the repurchased asset. In my Example 2 above, the basis of the 4 shares Cate repurchased is their historic cost ($150 per share) increased by the $10 per share disallowed loss. Thus, if Cate later sells those 4 shares, she will have a basis of $160 in those shares for purposes of determining gain or loss. 

In theory, the wash sale rule is simply a timing rule. It is inappropriate to allow a taxpayer to currently claim a loss when they wind up holding the exact same stock or securities. But, over time the tax basis rules should work out such that ultimately the correct amount is taxed to the taxpayer. 

What about basis adjustments when the wash sale occurs because of a repurchase made inside a retirement account? Rev. Rul. 2008-5 states that there is no basis adjustment with respect to a retirement account. There is an argument that Section 1091(d) should create Pro-Rata Rule basis in a traditional IRA. However, considering how highly technical and structured IRAs are, that is not a very likely outcome were the issue ever to be litigated. Further, that outcome would (quite oddly) give the taxpayer a different basis result based on whether they repurchased in a Roth retirement account or a traditional retirement account.

So what becomes of the basis? Does it just disappear? If the basis vanishes, the taxpayer obtains a worse wash sale result by repurchasing inside a retirement account. It seems odd that a taxpayer would receive a worse outcome for doing a repurchase through a retirement account instead of through a taxable brokerage account. 

Solving the Disappearing Basis Mystery

I have a theory that might solve the mystery. 

To get us started, consider that neither the Revenue Ruling nor Example 3 above discuss the “replacement property” in the taxable brokerage account. Here are two examples to ponder.

Example 4: Tim owns 1,000 shares of Domestic Equity Mutual Fund A (worth $50,000) he purchased for $60,000. It is held in a taxable brokerage account. On December 1, 2022, he sold Domestic Equity Mutual Fund A for $50,000 cash. He used the cash received to fund living expenses (food, clothing, heating bills, travel expenses, insurance, gasoline, etc.). On December 2, 2022, Tim purchased 1,000 shares of Domestic Equity Mutual Fund A in his Roth IRA. 

Example 5: Tim owns 1,000 shares of Domestic Equity Mutual Fund A (worth $50,000) he purchased for $60,000. It is held in a taxable brokerage account. On December 1, 2022, he exchanged all of his Domestic Equity Mutual Fund A for $50,000 worth of International Equity Mutual Fund B. On December 2, 2022, Tim purchased 1,000 shares of Domestic Equity Mutual Fund A in his Roth IRA. 

The wash sale rule disallows the $10,000 capital loss in both Example 4 and Example 5. But does Tim lose $10,000 of basis permanently? If he does, it’s an odd result considering that had he repurchased Domestic Equity Mutual Fund A in a taxable brokerage account (instead of in a retirement account), he would not lose that basis. 

I believe that there is a reasonable possibility that a court would rule that the $10,000 of basis shifts to the replacement property received in the wash sale. In Example 4, that conclusion leads Tim to no better position: he uses the cash for personal expenses, and there is no tax deduction for personal expenses. Further, I can’t imagine a court would give a step up in basis in Tim’s functional currency, the U.S. dollar. 

As applied to Example 5, where there has been a reinvestment in a taxable brokerage account, the equities of the situation might encourage some judges to find that Tim’s International Equity Mutual Fund B basis at a later sale is $60,000, not $50,000. 

Tim originally had $60,000 of basis in the system. While it is appropriate for a current loss to be disallowed, it is not appropriate for Tim’s basis in the system to be diminished in a situation where his overall taxable investment has not changed.

It’s one thing for the wash sale rule to operate to deny Tim a current loss deduction. It’s entirely another thing to interpret the wash sale rule to both deny current loss recognition and to permanently deny Tim $10,000 of basis. In its enactments of the wash sale rule and of the basis rules, Congress never manifested an intention for this one-two punch to bite Tim twice. If Tim sells the International Equity Mutual Fund B shares and recovers only $50,000 of basis he is inappropriately overtaxed. 

I believe some judges might determine that the IRS cannot have its cake (wash sale loss disallowance) and eat it too (permanent basis reduction). Basis exists to appropriately tax property transactions. Allowing Tim only $50,000 of future basis recovery over-taxes a later sale of his International Equity Mutual Fund B shares. While the IRS has a good argument that the wash sale rule disallowance should be spread to retirement account repurchases, it does not have a good argument that the overall result should be worsened if the repurchase occurs inside a retirement account.

Further, there is at least some risk to the IRS that a court would consider them to have reached just a bit by applying the wash sale rule to a repurchase inside a retirement account. The court might determine that what is good for the goose is good for the gander: if the IRS can reach a bit to apply the wash sale rule, the taxpayer can reach a bit to adjust the basis of the newly acquired securities in the taxable account.

The policies behind the rules point in the direction of allowing a taxpayer to add the disallowed loss to the basis of any replacement capital asset obtained through a direct exchange or a close-in-time use of the sales proceeds.

My proposed resolution has basis behave as it does in more familiar contexts. Say you received $50 from your grandmother when you were 12 years old. If you spent it on movie tickets and going bowling, the basis vanished for tax purposes. What if, instead, you purchased one share of stock of a publicly traded company for that $50? You’d get $50 of basis in that share of stock. Same with your first job: if you spend your first $1,000 W-2 paycheck on rent and groceries, tax basis disappears. But if you take that $1,000 and buy shares of ABC Mutual Fund in a taxable brokerage account, the basis stays attached to the mutual fund shares. Basis surviving when assets are reinvested in capital assets is a logical outcome.

Conclusion

Does anyone know for sure what happens to basis when the wash sale rule is tripped due to a repurchase in a retirement account? I believe it is still an unsolved mystery. 

Does basis vanish into the night? Or can it be preserved if the taxpayer reinvests in a capital asset in a brokerage account, as I have suggested?

Remember, the text of the Revenue Ruling does not affirmatively state that the basis simply disappears. Rather, all it says is that the basis does not get added to the taxpayer’s basis in the retirement account. To my mind, that’s a clue. It is not a definitive answer to the mystery. 

Now that we are 14 years removed from the issuance of Rev. Rul. 2008-5, it might be time for the IRS and Treasury Department to revisit the basis issue. The government could issue a regulation or another Revenue Ruling addressing the basis result in a situation similar to my Example 5. 

Of course, for taxpayers, this mystery is best avoided if possible. Repurchases should either (i) occur outside of the 61-day wash sale window or (ii) be of securities that are not the same or substantially identical to the sold securities.

I’ve also posted a video on YouTube with thoughts on this topic.

Lastly, the above is simply my technical analysis. It is not legal advice applicable to any one particular taxpayer or real life situation. 

FI Tax Guy can be your financial planner! Find out more by visiting mullaneyfinancial.com

Follow me on Twitter at @SeanMoneyandTax

This post is for entertainment and educational purposes only. It does not constitute accounting, financial, legal, or tax advice. Please consult with your advisor(s) regarding your personal accounting, financial, legal, and tax matters. Please also refer to the Disclaimer & Warning section found here.

Real Estate in Retirement Accounts

Should you hold rental real estate in a self-directed retirement account? Is real estate a great asset to own in a Roth IRA? Is holding real estate in a self-directed retirement account a hack that can help supercharge your path to financial independence? Below I discuss what it looks like to hold real estate in a self-directed IRA or 401(k), with a particular focus on those looking to achieve FI.

A Necessary Predicate

Before I proceed, I need to lay a necessary predicate. Those actively pursuing financial independence will fall into one of the two following groups:

Group 1: Invest in a diversified portfolio of equities and bonds.

Group 2: Invest in real estate and a diversified portfolio of equities and bonds.

Why is there no third group, real estate investors only? For two main reasons. First, many pursuing FI have no interest in owning rental real estate and/or desire to only own a small number of properties. Second, as a general rule, investing in only one sector of the economy (technology, financials, pharmaceuticals, utilities, real estate, etc.) leaves an investor dangerously undiversified and vulnerable to very particular risks to a degree diversified investors are not.

The rest of this post focuses on tax basketing for individuals in Group 2: those pursuing FI  and investing in rental real estate and a diversified portfolio of equities and bonds.

Stock Basis vs. Real Estate Basis

Recall that the basis of stock, bonds, mutual funds, and ETFs (what I will colloquially refer to as “stock basis”) is the amount you paid for the asset plus any distributions reinvested in the asset less any nondividend distributions (returns of capital). Stock basis is great, but for many in the FI community, its benefits are distant and significantly eroded by inflation.

Picture Jack and Jill, a married couple, each 25 years old and actively pursuing financial independence. They max out their IRAs and workplace retirement plans. They have a savings rate in excess of 50 percent, so they must invest in taxable accounts, and choose to invest in low-cost, well diversified index mutual funds. They target early retirement at age 40.

Other than very occasional tax loss harvesting, the basis Jack & Jill obtain in their taxable mutual fund accounts at age 25 will be meaningless to them until they are at least 40 years old. Even then, using something like the 4 percent withdrawal rule, they will touch only a small fraction of their basis every year. By then, the value of the basis they put in the mutual funds will have been significantly eroded by inflation.

But what if Jack and Jill instead decide that they will max out their IRAs and workplace retirement accounts (using stock and bond index funds), and then everything else will go into taxable rental real estate investments. What value does their basis have then? Much greater value, it turns out. Jack and Jill can immediately depreciate their rental real estate and start using their basis to reduce their taxable rental income from that property and other rental properties. Depending on their circumstances, they may be able to deduct some or all of any rental real estate loss against other taxable income.

When you invest in rental real estate in taxable accounts, your tax basis goes to work for you right away. When you invest in financial assets, your tax basis sits dormant, possibly for many years or the rest of your life. By the time you use your stock basis to obtain a tax benefit, the value of your stock basis (and thus the resulting tax benefit) may be severely diminished by inflation.

This strongly indicates you should house financial assets in retirement accounts and rental real estate in taxable accounts. House the rental real estate (pun intended) in taxable accounts where you can milk its basis for all it’s worth while housing the financial assets in retirement accounts.

Leverage and Tax Basis

You can use leverage to increase the tax value of rental real estate. A young couple will have to likely borrow some or all of the purchase price of their initial rental real estate investments. This can be advantageous from a tax perspective. Here’s an illustrative example:

Jack and Jill have $50,000 of cash to invest in a taxable account. They have decided to invest in a $250,000 fifth floor condominium to rent out. They borrow $200,000, purchase the property, and rent out the condo. In the first year they rent out the condo for a full year, they can get $9,091 ($250,000 divided by 27.5) in depreciation deductions and, assuming a 5% loan, almost $10,000 in interest deductions. Note this and all examples ignore any potential price allocation to land for simplicity.

Jack and Jill leveraged $50,000 into almost $19,000 in tax deductions in one year alone. Had they purchased $50,000 worth of financial assets, they would have received exactly nothing in tax deductions in the first full year, and the value of the $50,000 of basis would be eroding away to inflation. Even if they were able to tax loss harvest, at most the benefit would be a $3,000 deduction against their ordinary income.

In some cases, depreciation combined with other deductions causes rental real estate to produce a loss for tax purposes. Why put an asset that generates a tax loss in a retirement account?

If stock basis has such limited value, and rental real estate basis has such impactful, immediate value, why “exploit” stock basis in a taxable account while you neuter rental real estate basis in an IRA? It makes much more sense to utilize that rental real estate tax basis in a taxable account and put limited value stock basis in a retirement account.

Step-Up at Death

When you leave your heirs rental real estate in taxable accounts, the government gives your heirs hundreds of thousands of dollars worth of free tax deductions!

There’s no lack of content discussing the many tax benefits of real estate. Some of it discusses the step-up in basis at death and the ability to hold real estate in a self-directed retirement account. What little of this content acknowledges is that if you hold real estate in a self-directed retirement account, you lose the step-up in basis at death!

If you are at all concerned about Second Generation FI for your children, you need to consider this issue. The step-up in tax basis at death is an incredible opportunity for your heirs. Upon your death, your heirs get to re-depreciate your rental real estate based on the fair market value of the property at your death.

Here’s a comprehensive example.

Jake buys a small rental condo for $100,000 in 2019. He fully depreciates it over 27.5 years, saving significantly on his taxes. He dies in 2049 when the condo is worth $400,000. He leaves the condo to his adult son Jake Jr. He also leaves a Roth IRA with financial assets to Jake Jr. worth $400,000.

What result? Jake Jr. inherits the condo with a $400,000 tax basis and gets to depreciate that new $400,000 basis for 27.5 more years! This drastically reduces his taxable income from the property and may create a currently useable taxable loss. While Jake Jr. must withdraw the inherited Roth IRA within 10 years, the money from the Roth IRA is tax free to Jake Jr. And because Jake Jr houses the inherited Roth IRA at a discount brokerage (such as Vanguard, Fidelity, or Schwab), the Roth IRA pays minimal fees.

What if instead Jake had housed the financial assets in his taxable accounts and the rental property in his Roth IRA. First, the financial assets will produce interest, dividends, and capital gain distributions that will be taxable to Jake Jr. every year. Second, Jake Jr. will pay more in annual fees to a self-directed Roth IRA custodian. Further, Jake Jr. will lose the ability to claim any tax loss generated by the condo against his other income.

The effect is magnified if Jake Jr. leaves the rental property to his son, Jake III. Jake III will again get to step-up the basis in the condo to its fair market value when Jake Jr. dies and re-depreciate it! Over several generations the step-up in basis cycle can create potentially millions of dollars of tax depreciation deductions!

Rental Real Estate: Taxable Accounts and Retirement Accounts

If you are going to give up hundreds of thousands of dollars (possibly millions) of tax deductions for your heirs, you ought to have a compelling reason to do so. I do not believe there’s a compelling reason to house real estate in a retirement account and forego these free future tax deductions.

Roth IRAs are great for protecting the income generated by financial assets from taxation. The step-up in basis is great for protecting the income from rental real estate from taxation. Why waste a Roth IRA on real estate when your heirs will get a fantastic step-up in basis in your real estate to shield a significant portion of the income from taxation (and may possibly generate useable current real estate losses)?

All of this is magnified if the rental real estate is in a traditional IRA instead of a Roth IRA. Instead of depreciation and other deductions to shield rental income from taxation, every dollar you ever take from a traditional IRA will be subject to ordinary taxation (even if the underlying rental property is unprofitable). Combining this with self-directed retirement account custodian fees makes a traditional retirement account a terrible place to house rental real estate.

Stepped-Up Stock Basis

As discussed, the step-up in real estate basis is effective in reducing or eliminating taxable income rental real estate. But the step up in basis does nothing to reduce income from interest, dividends, and capital gain distributions generated by inherited financial assets. This further indicates that the step-up in basis is better used on real estate than on financial assets.

Other Considerations

Tax basis is not the only consideration in determining where to tax basket assets. Below is a run through of several other important considerations.

Costs

As of 2023, costs for investing in well diversified index funds in retirement accounts at discount brokerages are approaching zero. Costs for self-directed IRAs and 401(k)s are more substantial. Costs can include a set-up fee, annual account fees, one-off service fees, and fees for valuations.

Valuations

Starting at age 73, you must take RMDs from your traditional retirement accounts and employer Roth accounts. In the year after your death, certain heirs must take RMDs from your retirement accounts (including Roth IRAs). To do this, the recipient must know the value of each retirement account on December 31st of the prior year. For publicly-traded stock and bond based mutual funds and ETFs, the financial institution will simply report this information to you. For real estate, it is a very different ballgame. You will need to obtain a third party valuation, as the December 31st value of any particular piece of real estate is not readily apparent or known. This is an additional annual cost of owning real estate inside a retirement account.

Capital Gains

If you sell financial assets in a taxable account, you’re stuck with the capital gain, which will increase your federal (and possibly state) income tax bill. There are narrow and/or costly exceptions, including, the qualified opportunity zone program, which requires you to invest in a very specific type of investment that you may have absolutely no interest in investing in, for a minimum period of time. The qualified opportunity zone program can also apply to real estate capital gains.

The other exceptions to stock capital gain, including donations to charities, donor advised funds, and/or charitable trusts, are expensive, in that they require you to relinquish some or all of your economic ownership in order to avoid a taxable capital gain.

If you want to sell your rental real estate, you can use a Section 1031 “like-kind exchange” and simply exchange the rental property for another piece (or pieces) of rental real estate. This defers the capital gain on the sold property for as long as you hold onto the substitute property. Section 1031 exchange treatment is not available for financial assets.

While Section 1031 exchanges may not satisfy investors in every instance, the availability of Section 1031 exchanges is a reason to keep real estate in taxable accounts.

Rules, Rules, Rules

If you put your real estate in a retirement account, you voluntarily subject yourself to a whole host of rules. One is that you are not allowed to use the rental real estate for personal use. Another is that not allowed to personally manage or repair the property. Any violation of these rules can disqualify the retirement plan, resulting in a distribution of the property to the plan owner. This can result in a large taxable income hit and/or early distribution penalties if the owner is under age 59 ½.

Unrelated Debt Financed Income (“UDFI”) Tax

Is your rental property at all debt financed? If it is, and it is in an IRA, your IRA (including a Roth IRA) will be subject to income tax (the “unrelated business income tax”) on the portion of the taxable income that is attributable to the debt (the “unrelated debt financed income”). For example, if you have a condo that was purchased half with debt, half the income will be subject to tax (at the IRA level) as UDFI.

Further, as an entity your IRA is subject to taxation at very steep tax brackets. While the first $1,000 of UDFI is exempt from taxation, by the time the taxable UDFI exceeds $12,500, the IRA pays the highest individual marginal ordinary income tax rate (currently 37 percent) on the income.

There are UDFI workarounds. One is to roll a self directed IRA/Roth IRA to a self directed 401(k)/Roth 401(k). 401(k) plans are not subject to tax on UDFI generated by rental real estate. In order to move to a self directed 401(k)/Roth 401(k) plan, you must have a trade or business that can sustain the self directed 401(k) or self directed Roth 401(k).

If you roll from a Roth IRA to a self directed Roth 401(k), you solve your UDFI problem but you subject yourself to RMDs (and valuation issues) starting at age 73, reducing future tax free growth. You also added a requirement to file an annual Form 5500 tax return with the IRS if the self directed Roth 401(k) has $250,000 or more of assets. Another workaround is placing the real estate in the IRA/Roth IRA in a C corporation. This will lower the tax rate the UDFI is subject to down to 21 percent, but will also subject the non-UDFI income to that 21 percent tax rate.

Real Estate Losses

In some cases, depreciation combined with other deductions causes rental real estate to produce a loss for tax purposes. This can occur even if the property is “cash-flow positive” i.e., it produces cash income in excess of its cash expenses.

Why put an asset that generates a loss in a retirement account? Often times losses are suspended, meaning the rental property nets to zero on the tax return for that particular year. But the suspended loss is tracked and can be used in the future. Read this post for more information on deducting real estate losses.

Is the ability to use real estate losses from real estate held in taxable accounts limited? Absolutely. But it is fully eliminated if the real estate is in a retirement plan. Such losses can never be used on an individual’s tax returns.

Gilding the Lily

Discount brokerages have made this the best era to be a well diversified investor in equities and bonds. Costs associated with investing in index funds in retirement accounts are approaching zero.

This means equities and bonds reside in retirement accounts very well. Why do you need to gild the lily at that point? You have great investment options at a low cost.

To my mind, there is no compelling reason to reject this approach, particularly considering (1) depreciation and other tax advantages that help make rental real estate efficient in taxable accounts and (2) the burdens associated with housing real estate in retirement accounts.

Conclusion

In the vast majority of cases, if you want to own both financial assets (stocks/bonds/mutual funds/ETFs) and rental real estate as part of your portfolio, you are well advised to house your rental real estate in taxable accounts and save your retirement accounts for the financial assets.

It comes back to the tyranny of tactics. Real estate in an IRA sounds great, but when you peel back the onion, simplicity usually wins. Does this mean some with real estate in a retirement account will not achieve financial independence? Absolutely not. But the simpler path will keep your costs low and will likely be tax efficient.

FI Tax Guy can be your financial planner! Find out more by visiting mullaneyfinancial.com

Follow me on Twitter at @SeanMoneyandTax

This post is for entertainment and educational purposes only. It does not constitute accounting, financial, investment, legal, or tax advice. Please consult with your advisor(s) regarding your personal accounting, financial, investment, legal, and tax matters. Please also refer to the Disclaimer & Warning section found here.

Tax Basis for Beginners

What is Tax Basis?

To answer that question, let me posit two hypotheticals:

Hypothetical 1: Mark buys one share of Acme Industries stock for $100 on Monday. The following Monday he sells that share for $100.

Hypothetical 2: Judy buys one share of Kramerica Industries for $20 on Monday. On Thursday, Kramerica Industries announces the release of a new bottle that dispenses both ketchup and mustard, and the stock soars. On the following Monday, Judy sells her share of Kramerica Industries for $100.

What tax result? Do both Mark and Judy have $100 of taxable income? Of course not. We know that Mark has no taxable income and Judy has $80 of taxable income? But how do we know that? The answer: Basis!

Basis is the tax concept that ensures amounts are not taxed twice when they should not be. In Mark’s case, he has no real income when he sells the stock. Judy however, does have income. When she sells the Kramerica stock, she realizes the $80 gain.

Basis is what allows us to measure the appropriate gain or income to the seller of property. While we have a sense that Mark should not have had taxable income and Judy should have, without basis we have no way of measuring whether a disposition of property should trigger a taxable gain, loss, or nothing.

Generally, the basis of an asset is its historic cost, plus any capital improvements or additions made to the asset. In the case of a financial asset in a taxable account, basis is simply the purchase price plus reinvested distributions less any nondividend distributions (returns of capital).

Depreciation

Basis serves another function. Business assets are usually subject to a depreciation allowance on the theory that assets waste away from wear and tear over a useful life. The method and time period for depreciating an asset varies based on the asset. Residential real estate is depreciated in a straight line over 27.5 years. Most non-real estate property is depreciated using an accelerated method and over a shorter period. One business asset that never depreciated is land, on the theory that land has an indefinite useful life.

Each asset is depreciated based on its depreciable basis, which is generally historic cost plus capital improvements. For example, if you purchase a fourth floor residential condominium for $1,000,000 and rent it out, each full year it is used in the rental business you divide the $1,000,000 depreciable basis over 27.5 to come up with a depreciation deduction of $36,364, which lowers the taxable income from the rental activity, and may even be currently deductible against other income if the rental property produces a loss. Note that some of the basis may be attributable to land, which is good basis that can be recovered upon a sale, but it cannot be depreciated.

Step-up at Death

The tax code offers a tremendous benefit for those looking to facilitate Second Generation FI. The tax basis of inherited assets is “stepped-up” to the fair market value of the asset on the original owner’s date of death. This means, among other things, it is usually much better to leave an asset to an heir at death rather than to gift that asset to an heir during life. The asset left upon death has a stepped-up asset basis, while the gifted asset only has the original owner’s basis in the hands of the recipient.

I previously wrote an example of how this works:

William lives in a house he purchased in 1970 for $50,000. In 2019 the house is worth $950,000. If William gifts the house to his son Alan in 2019, Alan’s basis in the house is $50,000. However, if William leaves the house to Alan at William’s death, Alan’s basis in the house will be the fair market value of the house at William’s death.

Lastly, in order to qualify for the step-up at death, an asset must be held in a taxable account. Assets held in retirement accounts do not receive a step-up at death.

Tax Loss Harvesting

Basis is what makes tax loss harvesting possible. Picture Joey, who owns Blue Company stock worth $10,000. He purchased the stock a year ago for $13,000. He can sell his Blue Company stock and deduct the $3,000 loss on his tax return, realizing a nice benefit.

Tax loss harvesting is a neat tool in the tax planning tool box. But it’s a fools errand to succumb to the “tyranny of tactics” and arrange one’s portfolio around tax loss harvesting. At most, tax loss harvesting reduces your taxable income in any particular year by $3,000. Over the long run, that is not the way to build wealth and achieve financial freedom.

Sure, play the tax loss harvesting card when the right opportunity arises, but don’t structure your portfolio with dozens of holdings in the hopes you can get a $3,000 loss every year. Rather, structure your portfolio with your ultimate goal in mind, and if toward year-end an opportunity to do some tax loss harvesting arises, pounce on it.

Retirement Accounts

The term “basis” means something a bit different in the context of retirement accounts. Two points: First, it is possible to have basis in a traditional account. Generally this means that nondeductible, or “after-tax” contributions have been made to the account, and thus, in the future when there are taxable distributions a portion of the distribution will be offset by that basis.

Second, the assets inside of a retirement account (including a Roth account) do not have basis to the owner of the account. These assets do have basis, but that basis is never directly accessible to the owner of the account (in the way that depreciable basis or stock basis is accessible to the owner). Importantly, assets inside of a retirement account do not enjoy the step-up in basis at the owner’s death that assets in taxable accounts enjoy.

Conclusion

Tax basis is an important attribute to understand as you do tax planning. In two weeks I will build on this post to discuss in detail important implications of tax basis for those pursuing financial independence.

FI Tax Guy can be your financial planner! Find out more by visiting mullaneyfinancial.com

Follow me on Twitter: @SeanMoneyandTax

This post is for entertainment and educational purposes only. It does not constitute accounting, financial, investment, legal, or tax advice. Please consult with your advisor(s) regarding your personal accounting, financial, investment, legal, and tax matters. Please also refer to the Disclaimer & Warning section found here.

Tax Loss Harvesting

If you have individual stocks or other securities that have a loss in them, you may have a tax planning opportunity: tax loss harvesting.

First off, it is important to keep in mind that tax loss harvesting only applies to assets (such as stocks, bonds, mutual funds, ETFs, etc.) in taxable accounts. It does not apply to assets in retirement accounts and health savings accounts.

If you have assets in taxable accounts that have declined in value relative to your purchase price, you have an opportunity to tax loss harvest. Here’s a basic example:

Example 1: Mark purchased 100 shares of Kramerica stock two years ago for $100 a share ($10,000 total). Based on a disappointing test of an oil-tanker bladder system, Kramerica’s stock is now worth $70 per share. If Mark sells all 100 shares for $70, his total basis in the stock ($10,000) exceeds the amount he realizes on the sale ($7,000) by $3,000.

In Mark’s case, he has a $3,000 capital loss for tax purposes. Capital gains and losses from the sale of property (for most individuals, from securities) are different for tax purposes than other types of income, such as wages, rents, self-employment income, interest, and dividends (collectively, usually referred to as “ordinary income”). Federal income tax law does two things to capital gains and losses. First, it taxes capital gains at a lower tax rate than most other types of income. Second, and most importantly for the purposes of tax loss harvesting, it limits the ability of a capital loss to offset ordinary income.

Capital losses, such as Mark’s loss on Kramerica stock, can offset either capital gains or ordinary income, but only to the extent of $3,000 ($1,500 if the taxpayer files married filing separate) of ordinary income a year.

Thus, tax loss harvesting is a great play in two situations:

  1. A taxpayer has a large capital gain in a taxable year; and,
  2. A taxpayer has ordinary income and can trigger a $3,000 capital loss.

A second example can illustrate the first situation.

Example 2: Lucy sells stock with a historic cost basis of $30,000 for $50,000 in March. Thus, she will have to report a $20,000 capital gain on her tax return. If, however, Lucy has another stock/bond/mutual fund/ETF with a historic cost of $100,000 and a fair market value of $80,000, and she sells it by year-end, she will harvest the $20,000 loss in time to offset the previous $20,000 gain.

Taxpayers with significant capital gains during a year should review their taxable accounts towards year-end to see if there are any opportunities to harvest losses and offset existing capital gains.

For those taxpayers without capital gains, there still can be some opportunity to tax loss harvest.

Example 3: Edward anticipates making approximately $100,000 in 2021 in wages from his employer. If Edward can identify a stock/bond/mutual-fund/ETF with a built-in loss, he can sell the security and reduce his taxable income up to the lesser of the loss or $3,000 in 2021. If Edward owns the XYZ mutual fund with a historic basis of $5,000 and a current value of $2,000, he can sell it before year-end and reduce his taxable ordinary income from approximately $100,000 to approximately $97,000. The capital loss deduction is one taken on the first page of the Form 1040 and is not an “itemized deduction.” Thus, Edward gets the deduction regardless of whether he itemizes his deductions.

Note that Edward is limited in his ability to deduct capital losses in any one taxable year to $3,000. Let’s slightly revise the previous example.

Example 3A: The facts are the same as in Example 3, except the the stock Edward sells has a basis of $10,000. Thus, Edward’s current year capital loss is $8,000 ($10,000 basis less $2,000 sales price) instead of $3,000. However, Edward still can only deduct $3,000 because of the limit on taking capital losses against ordinary income. Thus, Edward’s 2021 taxable income is still approximately $97,000.

Edward can carry forward the excess unused capital loss ($5,000, which is the $8,000 actual loss less the $3,000 used loss) into future tax years. Thus, in 2022, he can offset capital gains and up to $3,000 of ordinary income by the $5,000 capital loss carried forward. If Edward has no capital gains or losses in 2022, he can deduct $3,000 of the $5,000 against his 2022 ordinary income, and then carryforward a $2,000 capital loss into 2023. Edward carries forward the capital loss until it is fully used.

Wash Sales

Tax loss harvesting sounds great, right? But with tax, there’s almost always a catch, and one exists here. The so-called “wash sale” rules.

They are best understood by understanding the concern they address. Say in our first Example Mark sells his 100 shares of Kramerica stock on December 15th to trigger the capital loss. Then on December 16th Mark buys 100 shares of Kramerica stock. Absent the wash sale rules, Mark has had no change in his overall economic position (he still owns 100 shares of Kramerica) yet he’s realized a $3,000 capital loss for tax purposes.

The wash sale rules step in to prevent this sort of gamesmanship. They disallow any loss on the sale of securities when the taxpayer buys the same or similar securities within the period starting 30 days before the loss sale and going through 30 days after the loss sale. The rule applies broadly. It applies to similar securities — for example, selling Vanguard’s S&P 500 index mutual fund at a loss and buying Fidelity’s S&P 500 index mutual fund. It applies to purchases of the same or similar securities by the taxpayer, the taxpayer’s spouse, and by entities controlled by the taxpayer and the taxpayer’s spouse. It can also potentially apply to purchases inside retirement accounts. The wash sale rule also bites to the extent of shares purchased through a dividend reinvestment program where the reinvestment occurs within the 61 day window described above.

Conclusion

Tax loss harvesting provides taxpayers a great opportunity to offset capital gains and possibly up to $3,000 of ordinary income. To work effectively for 2021, taxpayers must sell loss securities by December 31st and must be careful to avoid repurchasing the same or similar securities in a manner that triggers the wash sale rules and disallows the capital loss.

FI Tax Guy can be your financial planner! Find out more by visiting mullaneyfinancial.com

Follow me on Twitter: @SeanMoneyandTax

This post is for entertainment and educational purposes only. It does not constitute accounting, financial, investment, legal, or tax advice. Please consult with your advisor(s) regarding your personal accounting, financial, investment, legal, and tax matters. Please also refer to the Disclaimer & Warning section found here.