Tax-Loss Harvesting: A Tactical Strategy to Add Incremental Value

The effects of taxes on an investor's portfolio over the long term are substantial and fairly predictable. Given today's low-return environment, the productive value of each dollar invested must be considered. Within the context of a well-diversified portfolio, even the savviest of investors will suffer losses in core holdings from time to time. And as we near the end of fiscal year 2011, investors should consider how to make the most efficient use of those losses through tax-loss harvesting.

Investors can always add value by booking or harvesting losses but may find that some moments are more opportune than others. These can include instances of portfolio rebalancing or perhaps moving from an active to a passive strategy providing similar exposure. In general, tax-loss harvesting can be used to capitalize on opportunities that your existing exposures have provided in the short run. However, tax-avoidance strategies should not dominate your overall investing approach. We recommend that investors build out sound long-term portfolio allocations and use tax-loss harvesting strategies to add incremental value.

The Mechanics
Let's consider scenario one. You've been holding fund XYZ for some time, and to your dismay, the market hasn't gone your way. In the first scenario, you decide to hold on for the ride, and the market comes back so that you're even on the position. You haven't lost any money, and you don't have a taxable gain to report.

In scenario two, you sell XYZ at the bottom and roll into a fund that maintains nearly identical market exposure while tracking a different index or operating under a different structure--call it ABC. Upon sale of XYZ, you book a taxable loss. Effectively, this lowers your tax burden for the current period. In addition to the cash you rolled from XYZ to ABC, you could also invest (out of pocket) the amount by which your tax burden has been decreased: the amount that the government will eventually reimburse you for on your tax return.

As with the first scenario, the market makes a similar percentage swing back into your favor. The difference in scenario two is that you have a greater amount invested because of the taxable loss that you "harvested." Because you harvested the loss and reinvested it, the same percentage recovery delivers a higher total return.

Note the number of benefits that come in addition to a higher total return. The investor wasn't forced to alter his overall allocations because he rolled into an alternative providing very similar market exposure. This may not be possible in niche offerings, but finding a suitable alternative for a core fund shouldn't prove challenging. On top of the higher total return, the fact that taxes on those returns will be realized further into the future means that they are more likely to be taxed at 15% long-term capital gains rates.

Consider a real-world example. Perhaps you held a position in  iPath MSCI India Index ETN and intend to use it as a long-term core holding. You bought the note on July 8, 2011, after a quick 5% drop. Unfortunately, after holding the position for about three months, you find yourself down 26% on Oct. 3, 2011. You look to harvest your loss. On Oct. 4, 2011, you roll into iShares S&P India Nifty 50 (INDY), which has maintained a correlation to INP of 0.99 over the past year and should serve as a good alternative. By selling INP, you book the loss while maintaining your India allocation through INDY's Nifty 50 exposure. After the 30-day restriction period, you could shift back to INP. Assuming you switch back to INDY at the time of this writing (Oct. 28), the loss that you harvested would more than cover the tax on the 15.5% capital gain you realized. Without reinvestment of the harvested loss, you would currently have 85.5% of your initial position. If you had reinvested the harvested loss, as described earlier, you would have recouped nearly 96% of the original position.

The Wash Sale
Though the Internal Revenue Service has remained slightly ambiguous on the definitions, investors are not allowed to deduct losses from sales of securities in a "wash sale." According to the IRS, a wash sale occurs when you sell securities at a loss, and within 30 days before or after the sale, you do the following:

• Buy substantially identical securities
• Acquire substantially identical securities in a fully taxable trade
• Acquire a contract or option to buy substantially identical securities
• Acquire substantially identical securities for your IRA or Roth IRA

Effectively, this means that investors should be wary of rolling from one fund into another that tracks the same underlying index of securities. There are, however, indexes that maintain extremely high correlations while maintaining different structures or holding different baskets of securities. In these cases, the wash-sale rules would not be triggered. Even if you see slightly different performance between products tracking nonidentical indexes, you have the option to switch back into the original offering after 30 days.

If a suitable alternative is not present, the 30-day wash-sale rule can make it difficult to remain fully invested. While you may opt to test the ambiguous gray area that is the IRS definition of "substantially identical," we can't recommend that you use indexes that maintain significant overlap, and we would advise against using products that track the same index. Note that in our first example, we rolled into a product with a high correlation and nearly identical market exposure to the original holding, but a different index. Switching between products that track the same index such as  SPDR S&P 500 (SPY) and  iShares S&P 500 Index (IVV), for instance, may leave you vulnerable to trouble with the IRS. If you are insistent on rolling into a product tracking the same index, you may feel safer rolling into an offering with a different structure, perhaps an exchange-traded note instead of an exchange-traded fund, as was the case in aforementioned India exposure.

These tax-loss harvesting strategies need not be relegated to the use of ETFs and ETNs. One could certainly roll into or out of a mutual fund or equity security with the same goal in mind. In fact, given the varying structures and potentially high correlations, investors may use the strategy to further distance one's self from the triggering of a wash sale.

Saving Harvested Losses
Perhaps you're sitting on a loss within a particular position. You want to sell, and you want to "harvest" the loss, but you don't want to have to roll into a similar exposure. Under the generally accepted accounting principles, or GAAP, you are able to carry that loss forward. This means that you can consistently book taxable losses as they come about and apply them to your gains opportunistically. Note that harvested losses not used to offset gains can be used to offset up to $3,000 of income per year.

 As a disclaimer, we cannot speak to each investor's unique tax circumstances, and you should consult your tax advisor regarding the use of tax "carryovers."

Tax-Loss Harvesting Opportunities
Short-term dips in performance present us with the opportunity to tactically capitalize on drawdowns through tax-loss harvesting. Consider some of today's year-to-date returns. According to the Morningstar Financial Services Index and the Morningstar Materials Index, these sectors are down about 25% year to date. Among the size categories, the Morningstar Small Cap TR Index fell over 15.5%. Suitable alternatives within these asset classes will not be hard to find, so well-diversified investors can use these opportune moments to add incremental value going forward.

Remember that tax-loss harvesting doesn't allow an investor to offset taxes entirely. The process allows you to push your taxes into the future--kicking the can down the road, so to speak. On that basis, tax-loss harvesting can be a very powerful tool that allows your gains to build momentum over time. That said, your overarching goal should not be to avoid taxes. Investors should look to participate in securities that they believe will appreciate in value. Investors should look to build out sound long-term allocations and use tax-loss harvesting as a way to capitalize on very short-term opportunities. Further, we don't recommend being overly aggressive with pursuing tax strategies. If you make too many trades, for instance, trading costs may overwhelm the value-add of the harvested losses. For more information about tax strategies within your portfolio, please consult Morningstar's "Minimize Taxes" section of the "Real Life Finance" tab on Morningstar.com.