The Ins and Outs of Tax-Loss Selling

Christine Benz: Hi, I’m Christine Benz from Morningstar. Amid falling markets so far in 2022, tax-loss selling has been top of mind for a lot of investors. Joining me to discuss what you need to know if you’re thinking about doing tax-loss selling is tax and retirement planning specialist Ed Slott.

Ed, thank you so much for being here.

Ed Slott: Great to be back here with you. Thanks, Christine.

Benz: Great to have you here. Let's start by looking at tax-loss selling, which is usually the first strategy that comes to mind in down markets. Can you outline the benefits?

Slott: Well, obviously, you can dump losers and get a tax benefit off capital gains. But as an overall theme here, tax-loss selling is only when markets, like you said, are down. But by the time somebody sees this, they could be way up. I remember doing an interview, a live piece on CNBC Power Lunch or something like that, and the market was falling, was down 500 points, and I came on the show just to do that. And when we went to air, which is live, and they have the big board behind them, the market was up 500 points. So, what do we talk about now?

Benz: The markets can be very ephemeral, obviously. But my guess is that investors do have widespread losses across their portfolios today.

Slott: Not as many as you think.

Benz: Stocks are down, bonds are down.

Slott: Not as many as you think. Now, at the end of the year, by now, I'd say after the first week or so in December, they may be surprised at the capital gains they have thrown off by mutual funds. Especially when you've had a lot of volatility during the year, you know when you get the fund distributions reported, they throw off tons of capital gains. So, you may even need more losses than you think. So, I would say, take more losses than you think just to cushion, unless you already know what the capital gain distributions are. And there's no risk in overdoing the losses because whatever you can't use, you can carry over to future years.

Benz: I want to talk about that. You're comparing your cost basis in a position to its current price, and if you are higher on your cost basis, then you've got a loss. Assuming you do have more losses than you're able to use to offset gains this year, can we talk about the carryforward process? What sort of documentation people need to be keeping?

Slott: Well always keep your brokerage statements. And remember, this is already reported to the IRS on these 1099-Bs. That was not the case, you may recall; many, many years ago, they only gave you the selling price. I guess, IRS picked up on this over the years and say, people were just putting in any cost they could find. There was no documentation. You had to keep your own--and I'm really dating myself now--buy slips. I don't even know if that's a thing; there were these little sheets. They look like this, a little piece of paper with a buy slip. Well, now, that's all online, everybody knows it. Keep those. What I would do is download that year-end statement, it has everything and then keep that. Even for people who like me, say, you only need a few years, three to five years of old tax information. If you're still holding an old stock, you keep those year-end statements, those 1099-Bs that you get from the banks and brokers and so forth, usually in January of the next year. Keep them for as long as you've held those stocks and you may have to dig out old ones and you may have to make adjustments for things like reinvested dividends. Many people overpay the tax on their capital gains because they don't make adjustments for reinvested dividends that they already paid tax on.

Benz: I want to ask about how cost-basis elections fit into this, because many people are dollar-cost averagers where they've purchased their positions over a period of years. Can you talk about that? And specifically, how it works for mutual funds? Typically, the default is the average method for calculating cost basis. Can you talk about what people need to know about that?

Slott: You can do that. Like you said, it's a default and they give you all that information. But if you instead want to ,say, well, I don't want to use the average cost; I'd like to use this other cost and these shares I bought at a different time, that's known as specific identification where you're identifying certain securities you're selling. You'd say, I'm selling those securities, not just using the average. But then, you have to stick with that and again, have the documentation to back it up. In other words, you can't double dip, keep going back to that same one you bought for a certain price, maybe a higher price that produces a larger loss or less of a gain, for example. So, you can do both, but it all comes down to documentation. And the documentation on specific identification, which shares are actually being sold, you may not find on some of your year-end statements. That's your own personal recordkeeping.

Benz: And my understanding is that if you've used that averaging method before, you can't turn around and use some other method. Is that correct?

Slott: Right. You can't double dip. They want to make sure you're not using the most advantageous cost, usually the highest cost, more than once.

Benz: Let's talk about some of the things that can go wrong and trip people up in the realm of tax-loss selling, especially if their plan is to buy something along the lines of what they've just sold. Can you talk about the wash-sale rule and what people need to know if they want to maintain exposure to that same part of the market that they've just sold themselves out of?

Slott: Well, as you probably also know, that changed in recent years. Yes, there's a wash-sale rule only when you sell losses. Some people don't understand this. You can sell a stock at a gain and buy it back. The rule is only for losses. The idea is, you can't have a paper loss and then buy it right back like nothing happened just to generate a tax loss. So, there's a 30-day waiting period before or after--not just after--before or after you sell that stock and buy what's called a substantially identical security later on. Now, you can always buy something similar but not exactly the same. So, there's wiggle room there. But the reason it's different now, again, back to the IRS reporting. On those year-end statements from the brokers, you're going to see the wash-sale amount. You're going to see it right on there. So, IRS already knows this. Now, if you lose a loss because of the wash sale, and you'll see it on your statement if that happened, you don't really lose the loss. You lose it for this year or the year you sold. But it gets added back. You don't lose it forever. You just can't take it this year. It sort of goes in the bank for you for future years.

Benz: I'm curious, Ed. Have you heard of investors actually running into this issue where they do run afoul of the wash-sale rule?

Slott: No, because I really haven't seen it. I don't want – the minute I say that, people are going to say, well, how are they going to know? I never like to answer that question. And I get even advisors and accountants always ask me, "Well, how are they going to know?" And I give them the same answer: "I don't know. Ask the guy in the cell next to you." I don't know what the answer to that is. But I'll tell you a story. About 10 years ago, IRS made it clear with an announcement--maybe even more than 10 years ago--on how are they going to know on this wash sale rule. And the question was does it apply if you buy the same security back in an IRA? And IRS said, yes, it does. So, a writer for The New York Times called me and said he's doing a story on this, and he quoted me, and I said the same thing. You have to report. He says, but how are they going to know? And I said, I'm not going there. I saw the article come out about a week later, and he quoted a former IRS commissioner saying they'll never know. Well, I wouldn't follow that advice. You have to do what's right always. Every answer seems to come down to keeping your own records. But there are records officially on these 1099-Bs of the wash-sale amounts.

Benz: Go by the rules but understand that tax-loss selling can be kind of a silver lining in a difficult market like this one.

Slott: Yeah, yeah. And as I said before, I think I would take more losses than you think you need because when you do your taxes ... I always found that when I did tax returns people, all of a sudden, where did these gains come? Oh, I had that mutual fund. It threw up all these gains. And people don't think that happens in a down market. It happens more in a down market because there's more selloff.

Benz: Well, Ed, always great to get your insights. Thank you so much for being here.

Slott: Thanks, Christine.

Benz: Thanks for watching. I’m Christine Benz from Morningstar.