Tax loss harvesting

When you use tax loss harvesting, you replace securities, such as ETFs or stocks, that trade at a loss. This process systematically lowers your portfolio's cost basis. Your ability to deduct the resulting capital losses depends on the capital loss limits and whether the wash sale rule applies.

In the ETF process described by Wealthfront, your ETF trading at a loss is sold under the right circumstances. Your replacement ETF tracks a different but highly correlated index. The stated purpose is to maintain your portfolio's risk and return characteristics while replacing the investment.

Your harvested losses do not necessarily produce a full current tax benefit. Wealthfront's analysis assumes full use of losses against gains, while acknowledging that you may have no capital gains or too few gains to offset. Your available gains and the deduction limits therefore matter when you consider how losses can be used.

If you are a taxpayer other than a corporation, you can deduct losses from sales or exchanges of capital assets up to your gains from those sales or exchanges. If your losses exceed your gains, you can deduct an additional amount. That additional deduction is the smaller of your excess losses or $3,000.

If you are married and file a separate return, the additional deduction limit is $1,500 instead of $3,000. The smaller amount rule still applies. If your excess losses are below your applicable dollar limit, your additional deduction is limited to those excess losses.

Your $3,000 limit, or $1,500 limit if you are married filing separately, applies to the additional deduction after your losses offset your capital gains. It does not limit the amount of capital gains that your capital losses can offset under this rule.

If you operate through a corporation, a different deduction limit applies to the corporation. For your corporation, deductible capital asset sale or exchange losses cannot exceed gains from such transactions. The corporate rule does not provide the additional deduction available to taxpayers other than corporations.

If you are a taxpayer other than a corporation, excess losses remaining after you offset capital gains and use the permitted annual income deduction can be carried forward indefinitely. For each year you use a carryover, the ceiling beyond gain offsets is $1,500 on a married separate return and $3,000 otherwise.

If you are a taxpayer other than a corporation and have a net capital loss, section 1212 distinguishes your short term and long term amounts. The excess of your net short term capital loss over your net long term capital gain becomes a short term capital loss in the succeeding taxable year.

Under this provision, you carry a net long term loss exceeding net short term gains into next year with its long term character intact. Your short term and long term categories therefore remain relevant to the treatment of your losses in the following year.

You cannot deduct a claimed loss under section 165 from selling or otherwise disposing of stock or securities when the acquisition conditions in section 1091 apply. The period begins 30 days before your sale or disposition and ends 30 days after it. Including your sale date, that period covers 61 calendar days.

The rule applies if you purchase substantially identical stock or securities during that period in any of your accounts, including IRAs, or if your spouse purchases them during that period and you file jointly. It also covers an acquisition through an exchange in which the entire gain or loss is recognized by law. Entering into a contract or option to acquire substantially identical stock or securities in those ways can also trigger the rule.

For this rule, your stock or securities include contracts or options to acquire or sell stock or securities, except as provided in regulations. The loss disallowance has an exception if you are a dealer in stock or securities and sustain the loss in a transaction made in the ordinary course of that business.

Your purchases before a loss sale fall within the specified period just as purchases after the sale do. The statutory period includes both sides of your sale date. A description that considers only your purchases after the sale would leave out the preceding 30 days covered by the rule.

If your replacement acquisition causes a loss to be nondeductible under section 1091 or corresponding provisions of prior internal revenue laws, the acquired property's basis follows a specific rule. You start with the basis of the substantially identical stock or securities sold or disposed of. You then increase or decrease that basis, as appropriate, for any difference between your acquisition price and your sale or disposition price.

In Wealthfront's illustrative example involving 10 replacement shares, you add the disallowed loss on the 10 shares subject to the wash sale rule to the cost basis of your 10 new shares. In that situation, you can get the tax benefit of the loss when you sell those new shares.

If you acquire fewer shares or securities than you sold or otherwise disposed of, regulations determine which particular sales produce a nondeductible loss. If you acquire at least as many as you sold or disposed of, regulations determine which particular acquisitions caused the loss to be nondeductible. Both rules also cover amounts subject to your contract or option to acquire.

For your portfolio of index based ETFs, Wealthfront's discussion says to use two securities tracking different indexes to avoid the wash sale rule's substantially identical clause. It states that swapping your ETF for another issuer's ETF tracking the same index would violate that clause.

In the service process Wealthfront describes, your alternative ETF tracks a different but highly correlated index and is held for a minimum of 30 days to help avoid wash sales. Section 1091 requires you to consider acquisitions in the preceding 30 days, together with those through the thirtieth day following your loss sale.

If you are required to file Form 1099 B for a sale of a covered security, the reporting instructions specify several fields. You report the acquisition date in box 1b and cost or other basis in box 1e. You report accrued market discount in box 1f and the loss disallowed because of a wash sale in box 1g.

In box 2, you report whether the gain or loss is short term or long term and whether any portion is ordinary. These reporting requirements apply to each covered security sale for which you are required to file the form.

As the filer, you must report a loss disallowed under section 1091 when both the sale and purchase occur in the same account and involve covered securities with the same CUSIP number. You may report other losses disallowed under section 1091 in box 1g, but you are not required to report all of them there.

For example, as the filer, you may report a disallowed loss when a security is sold in one account and repurchased in a different account. You must increase the adjusted basis of the acquired securities by the disallowed loss you report in box 1g. The reporting instructions expressly distinguish your mandatory reporting from your permitted reporting.

If your corporation has a net capital loss, its carryback generally reaches each of the three preceding taxable years. The carryback applies only to the extent the loss is not attributable to a foreign expropriation capital loss. It also cannot increase or produce a net operating loss, as defined in section 172(c), in the year receiving the carryback.

Your corporation's net capital loss generally carries forward to each of the five succeeding taxable years. The portion attributable to a foreign expropriation loss instead carries forward to each of the 10 succeeding taxable years. Your corporation treats the loss as a short term capital loss in each eligible year.

Your corporation carries the entire loss first to the earliest eligible year. The amount carried to each later eligible year is the excess over total capital gain net income in the earlier eligible years. For that calculation, your corporation computes the earlier years' capital gain net income without regard to net capital losses for the loss year or any subsequent year.

If the net operating loss restriction prevents your corporation from carrying the loss back in full to a preceding year, an additional limit applies to that calculation. Your corporation cannot treat that preceding year's capital gain net income as greater than the loss amount that the restriction permits it to carry back to that year.

Your portfolio's cost basis systematically falls when tax loss harvesting replaces securities trading at a loss. A portfolio with a low cost basis generally requires more careful disposition in the future. That future basis consequence is part of the process described in Wealthfront's discussion.

Wealthfront describes tax loss harvesting as a tactical approach that should not interfere with your strategic investment objectives. Its examples include broad diversification through an optimal asset allocation, disciplined and tax efficient rebalancing, and low cost indexing.