If you have capital gains and underperforming investments in your investment portfolio, you could benefit from tax-loss harvesting (also known as tax selling). In this article from our resident accounting expert at Franklin Prosperity Report, Shelly Casella-Dercole, CPA, partner at Eder, Casella & Co. in McHenry, Ill. the important keys you need to know to maximize this tax-saving tool are outlined.

Tax-loss harvesting is a strategy used by savvy investment and tax advisers to reduce your personal tax liability by selling losers in your portfolio and using those losses to offset capital gains.

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While the losses generated will go to offset any capital gains first, you can use any excess losses to offset up to $3,000 ($1,500 if married filing separately) of ordinary taxable income each year, saving you even more. Any losses not used will carry forward indefinitely to future years.

Capitalize on Temporary Decreases in an Investments Value

Tax-loss harvesting also can be used as a way to capitalize on temporary dips in an investments performance and increase the long-term return. When an investment decreases in value, you can harvest the loss and use the proceeds from the sale, as well as the tax savings, and reinvest that amount in a similar performing investment (but not the same or substantially similar investment see the related wash-sale rules below).

Because your investment in the new security will be higher than the value of the old security due to the tax savings, your long-term total return will be higher. Consider this example: You have capital gains from stock sales earlier in the year of $20,000. Assuming your capital gains tax rate is 15 percent, your tax on this gain is $3,000.

You also own XYZ stock that you bought for $60,000 and is worth only $25,000 a loss of $35,000. If you sell XYZ stock and use that loss to offset the $20,000 of capital gains and $3,000 of ordinary taxable income at 25 percent (saving you another $750), your total tax savings would be $3,750.

Therefore, you will have $25,000 plus $3,750 for a total $28,750 to reinvest in another investment. Assuming the stock you sold and the new investment both increase 5 percent a year for the next five years, you will have $36,693 at the end of that period if you used a tax-loss harvesting strategy.

If you stayed the course, however, and didnt sell the original stock for a loss, you would have only $31,907 ($4,786 less). In this way, tax-loss harvesting can be a powerful tool when used properly.

Wash-Sale Rules

The big pitfall to tax-loss harvesting that you need to be careful of is the Internal Revenue Services wash-sale rules. These rules are intended to prevent you from taking a deductible loss on investments that you continue to hold. As such, you cant deduct losses on investments if the same or substantially similar securities are purchased 30 days before or 30 days after the sale.

While the IRS has yet to issue any clear guidance on what would be considered substantially similar, the bottom line to play it safe is to avoid purchasing any other investments that are tied to the same underlying index of securities or have significant overlap in securities held.

The wash-sale rules apply to all your accounts, including your retirement accounts. Therefore, you need to monitor the situation carefully if you have more than one investment/retirement account.

These rules also apply to purchases made through dividend reinvestments in any of your retirement or taxable accounts. Consequently, if you continue to hold the same or substantially similar investments in any of your accounts, you will need to determine the timing of any dividend reinvestments 30 days to either side of the sale before deciding whether to harvest a loss.

Should you inadvertently sell an investment for a loss and the wash-sale rules apply to that sale, the loss will not be currently deductible. Instead the disallowed loss will be added to the basis of the new investment (as long as the purchase of the new investment occurred in a taxable account and not in a retirement account) so that you will eventually get to take advantage of the loss.

If the purchase of the new investment occurred in a retirement account, the IRS does not allow the disallowed loss to be used as basis for the new asset in the retirement account, and thus you will lose the loss forever, which is the worst possible scenario.

The Simple Roadmap That Helped Create Over $41 Billion in New Wealth

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