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Tax-Gain Harvesting

A few months ago, we discussed saving on taxes via tax-loss harvesting. As a refresher, the idea of tax-loss harvesting is to:

  1. Sell an investment with a current value that’s lower than your cost basis in the investment (so that you can claim the tax loss), and
  2. Buy a similar (though not “substantially identical”) investment at the same time so as to not dramatically throw off your asset allocation.

But sometimes it can make sense to do the opposite: harvest your capital gains.

Specifically, if your current tax rate for capital gains is significantly lower than what you expect it to be in the future, it can sometimes make sense to:

  1. Sell an investment with a market value that’s greater than your cost basis in the investment (and pay any applicable capital gains tax now, at your lower tax rate), and
  2. Use the proceeds to buy a similar investment so you don’t mess up your asset allocation.

Are You in the 10% or 15% Tax Bracket?

For investors in the 10% or 15% tax brackets, the tax rate on long-term capital gains is currently 0%, which can make tax-gain harvesting particularly advantageous.

Example: For this year, Diane is in the 10% income tax bracket. Therefore, under current tax law, her tax rate on long-term capital gains is 0%. Diane expects, however, to move into the 25% tax bracket next year as a result of a job she’ll be starting this fall — meaning that her tax rate on long-term capital gains will be higher than 0% in the future.

Aside from the investments Diane owns in her IRAs, Diane’s only holding is $4,000 in Vanguard Total Stock Market ETF, which she has held for more than one year. Her cost basis in the ETF is $3,000. She can sell the ETF and claim a $1,000 long-term capital gain, on which she’ll pay $0 in taxes. Then she can buy a similar mutual fund or ETF for $4,000. As a result, her cost basis in the new investment will be $4,000 rather than $3,000, meaning her capital gain will be smaller when she eventually sells it in the future.

It’s important to note, however, that if an investor harvested too large of a gain, the gain itself could push her into a higher tax bracket, thereby meaning part of the gain would no longer qualify for the 0% tax rate.

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Comments

  1. “She can sell the ETF and claim a $1,000 long-term capital gain, on which she’ll pay $0 in taxes. Then she can buy a similar mutual fund or ETF for $4,000.”

    Just a quick note — she can purchase the same exact mutual fund or ETF when claiming a capital gain. There is no wash sale rule for capital gains.

  2. Charlie, thank you for bringing that up.

    My concern there is with the “economic substance doctrine.”

    In this IRS guidance on the topic, the following statement is included:

    “The following facts and circumstances tend to show that application of the economic substance doctrine may be appropriate. [...]

    • Transaction has no credible business purpose apart from federal tax benefits
    • Transaction has no meaningful potential for profit apart from tax benefits
    • Transaction has no significant risk of loss”

    It sounds to me like tax gain harvesting using the exact same investment (repurchased immediately) would meet those criteria.

    But I freely admit that I’m not an expert on this topic. So if you (or anybody else reading) can provide any additional clarification, please do.

  3. Mike,
    I heard about your blog thru Manisha Thakor and have been following you for several months now. I am not new to managing money and have, over the years, read a good chunk of the literature for individual investors (from Benjamin Graham ["The Intelligent Investor,"] to Burt Malkiel to Andrew Tobias to William Bernstein, etc.) Last year I decided to tackle the CFP and am almost done. I find your blog (and books) among the clearest, most concise, most useful, accessible resources to turn to for candid, cut-to-the-chase, everyday advice for lay investors. I just wanted to thank you. You do a great public service!

    With best wishes,
    Lisa

  4. Thank you for such kind words, Lisa. Good luck on the CFP exam!

  5. Good, non-obvious advice. Thanks.

  6. susie bell says:

    There are some products online that can help with cost basis issues, particularly when it comes to tax optimization and sales methodology. The tool can help determine strategy on selling a security or fund in order to minimize capital gains. It’s very easy to play “what if” scenarios on the software. The impact on the capital gains numbers can be significant. Worth checking out.

  7. So would the wash sale rule apply here like it would with tax loss harvesting? Because from what you reference in the tax code, it seems like you shouldn’t be doing this at all. But if I’m misinterpreting it, then is there some type of 30 day rule?

    Thanks

  8. Harry,

    As I mentioned to Charlie, I’m not an expert on the economic substance doctrine. But I would think that as long as you can show that your position has meaningfully changed (either by using a fund that’s different in some way, or by waiting for a period of time before re-buying the same fund), you wouldn’t have to worry about it, because there would be more to the transaction than simply a not-actually-real-economic change to achieve a tax benefit.

  9. I am not a tax expert, either, but even the IRS says “A wash sale occurs when you sell or otherwise dispose of stock or securities (including a contract or option to acquire or sell stock or securities) at a loss and, within 30 days before or after the sale or disposition, you…”
    Selling stock at a gain is specifically not a wash sale.

    Why do you think that the economic substance doctrine is relevant to the discussion? If it were, the Wash Sale rule wouldn’t even need to exist, since the transaction would already be disallowed by said doctrine. The Cornell site you linked to to define the doctrine has an “Exception for personal transactions of individuals” to boot.

  10. Steve,

    I’m not necessarily saying the economic substance doctrine does apply. I’m simply stating that my understanding of it is not sufficient to rule out that possibility.

    I agree that what we’re talking about is not a wash sale. But, well, wash sales are not what I’m talking about.

    As far as why both rules exist, the wash sale rule was around for many years before the economic substance doctrine was put into the code (in 2010). I could see two possible explanations (in addition to the one you appear to be suggesting, which is that they apply to different situations):
    1) Lawmakers wanted to keep the wash sale rule because of how (relatively) explicit it is with regard to situations in which it applies.
    2) Lawmakers thought that getting rid of the wash sale rule would cause more confusion than it would alleviate.

    As far as the exception you pointed out, I’m not 100% certain that investing counts as a “personal transaction” that is not an “activity engaged in for the production of income.”

    But, again, I’m not arguing that the economic substance doctrine does apply. I’m simply stating that my understanding of it is not sufficient to rule out that possibility.

  11. My understanding of fluid mechanics is not sufficient to rule out the possibility that it applies, either…

If you want to discuss this article, I recommend starting a conversation over at the Bogleheads investing forum.
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