Optimizing the impact of year-end tax loss selling

Selling securities at a loss can be a meaningful way to reduce your net realized gains for the year and ultimately your year-end tax liability, but there are deeper strategies one should consider, not only to maximize the absolute dollar amount of loss taken, but to optimize the impact of these actions on a long-term investment portfolio. Such strategies can include being tactical with your approach, understanding the execution convention (i.e., tax policy) of your trading platform, and having a view of the general market or security in question on a go-forward basis, to arrive at the optimal means of extracting any unrealized losses available.

Being tactical in your approach involves recognizing that shares of any particular security are often purchased on more than one occasion.  Each time this occurs, the shares purchased – often referred to as a tax lot – are assigned a cost basis commensurate with the price per share at which they were purchased.  Over time, an investor may end up with several tax lots, each lot having its own unrealized gain or loss in most instances, depending on whether the share price went up or down after each lot was acquired.

If the share price went up after a lot was initially purchased, an investor will have an unrealized gain – a short-term unrealized gain if the lot has been held for less than one year, and a long-term unrealized gain if the lot has been held for more than one year.  If the price per share went down after an initial purchase, an investor will have an unrealized loss – an unrealized short-term loss or long-term loss, depending on how long each lot has been held and as previously described above.

The point here is that ALL tax lots may not reflect an unrealized loss and so ALL shares may not need to be sold to extract the maximum dollar amount of loss possible. Simply be tactical in this regard and sell ONLY those share lots with unrealized losses. Also, be cognizant of the fact that long-term losses are first used to offset long-term gains (reducing realized gains that would otherwise be taxed at up to 20% or more), that short-term losses are first used offset short-term gains (reducing realized gains that would otherwise be taxed at ordinary income rates that are often much higher), and that any excess losses that remain can be used to offset up to $3,000 of ordinary income each year, and/or be carried forward in perpetuity to offset future gains and/or income.

Understanding the system convention of your trading platform can be another important consideration, as it relates to extracting tax losses and making sure that the execution of your trades is in line with your intent.  In this regard, an investor typically chooses or receives a default tax policy for their non-retirement account at the time the account is opened. The default or chosen tax policy then dictates the order in which tax lots are sold for any given trade, unless and until specified otherwise. Tax policies may include a LIFO approach, where lots are sold on a last-in, first-out basis, a FIFO approach, where lots are sold on a first-in, first-out basis, one that minimizes gains with all long-term lots sold first, one that minimizes gains with all short-term lots sold first, or one that maximizes gains, just to name a few.

The tax policy or trading convention in effect for a non-retirement account can be problematic at times, particularly if you have short-term lots and long-term lots, each with distinct unrealized gains and losses.  For example, if the chosen tax policy calls for minimizing gains/long-term first, and you have four equal-sized share lots – two short-term lots (one with a gain, one with a loss) and two long-term lots (one with a gain, one with a loss) – and you place a trade to sell half of all shares outstanding, only the long-term lots would be sold; minimize gain/LONG-TERM FIRST, right?  Here, you take the chance of realizing little, if anything, in the way of net losses. In this instance, the strategy would be to manually assign the short-term lot with an unrealized loss to be part of the total number of shares being sold, effectively overriding the default trading convention of selling long-term lots first and extracting the maximum dollar amount of loss possible.  Many trading platforms will offer you an option in this regard, or you can simply call your broker or investment professional and instruct them to assign sold shares to the lots that you specify, as opposed to having lots assigned/sold by default convention.

In addition to being tactical with your approach and understanding the system convention (i.e. tax policy) of your trading platform, having a view of the market or security targeted for tax loss selling can also be beneficial.  For example, if your goal is to exit a position entirely, perhaps you need only to sell the security with unrealized loss outright and reinvest the proceeds elsewhere.  If you have a neutral view of the market/security in question and wish to maintain the same exposure and/or a stream of income, perhaps selling the security or tax lots with losses and swapping into a different security with similar characteristics is the answer – here, you not only take the tax loss, but maintain exposure to the part of the market you’re interested in and preserve the desired stream of income as well.

For those who wish to maintain exposure to a security over a longer period of time and have stronger feelings about the direction a security may take in the near-term, here are a couple other approaches to consider:  if you think the share price of a particular security will increase in the near-term, double your position on the lots with unrealized losses now, wait at least 31 days, and then sell the original lots to extract the tax losses – assuming the unrealized losses still exist; if you think the share price of a particular security will decrease in the near-term, sell the lots with unrealized losses now, wait at least 31 days, and then buy those same shares back.  If you’re right in either instance, there will be a net benefit to the approach you’ve selected. Also, waiting at least 31 days in between the purchase and sale of the same security prevents you from violating what’s known as the wash sale rule, which would disallow any losses realized from buying and selling the same security within a shorter period of time.

Being tactical with your lax loss selling allows you to sell only those tax lots with unrealized losses, thereby minimizing trading costs and maximizing the dollar amount of total tax loss extracted.  Understanding the system convention (i.e. default tax policy) of your trading platform ensures that your trading activity is in line with the intended outcome of your actions. Finally, incorporating a view of the market or security you’re dealing with can better position a portfolio for the near-term environment you anticipate.  No one likes paying more in taxes than they need to. Paying attention to all these strategies can optimize the impact of your tax loss selling and help bring good tidings to you and your kin.

Rossi is senior vice president and senior equity strategist at Canandaigua National Bank & Trust Co.