Strong Market Makes Tax-Loss Selling Especially Valuable

The S&P 500 has posted nearly a 20% year-to-date gain through Sept. 10. So why on earth should you be scouting around for tax-loss sale candidates? 

First, the timing question: Yes, you often hear about tax-loss selling in November and December, as you begin getting your arms around your tax position for the calendar year. But you can sell a loser from your taxable account anytime one of your securities is trading lower than your purchase price, book the loss, and use that loss to offset any capital gains. If your capital losses exceed your capital gains, you can use the excess to offset up to $3,000 in ordinary income (including wages) for that year. Any unused losses can be carried forward to future years. If you'd like to maintain a consistent economic position in that asset class or sector, you can purchase a similar security right away. (Just be sure you don't buy the same or a "substantially identical" security, which has the potential to trigger the Internal Revenue Service's wash-sale rule.) 

Tax-loss selling is often discussed as a way to make lemonade in lousy markets. But perhaps somewhat counterintuitively, the fact that it has been such a good year for U.S. equities makes seeking out tax-loss candidates a particularly valuable exercise right now. If you haven't rebalanced your portfolio recently, it's a good bet that it's skewing toward stocks, especially U.S. equities; identifying tax-loss sale candidates can help reduce the tax pain of putting your portfolio back into alignment. The strong equity market also increases the likelihood that funds will pay out capital gains to shareholders; engaging in tax-loss selling can help offset those unwanted payouts. 

Unhappy Hunting Grounds
Even though U.S. stocks have performed well, most investors can probably find pockets of losses in their portfolios. In fact, more than 4,700 of the companies in Morningstar's equity database had a negative return for the year to date through Sept. 10, according to our  Premium Stock Screener, and more than 3,800 of those had posted losses of more than 10%. 

Some of those losers are, not surprisingly, tiny firms that appear in few mainstream investors' portfolios. But there are some widely held names in the 10%-plus loss club, too, including multinationals such as  BHP Billiton (BHP) and  Rio Tinto (RIO). Commodity-oriented firms whose fortunes are tied closely to the global economy are well-represented on the list of companies with market caps of more than $25 billion and year-to-date losses exceeding 10%. 

There are also whole fund categories that are well into the red for the year to date, especially in and around the emerging-markets sectors. Diversified emerging-markets funds have posted a 4% average loss for the year to date, and funds concentrated on Latin America and India have lost an average of 10.5% and 27.0%, respectively, through Sept. 10. Specialty precious-metals equity funds have also been hard-hit, with an average loss of 38% for the year to date. Funds in those areas could be ripe for pruning, especially for newly arrived investors who weren't around for the good times. 

Certain bond-fund types might also be worthy tax-loss sale candidates, as the recent interest-rate shock has sent categories such as long-term bond and emerging-markets bond funds well into the red. Emerging-markets bond funds are particularly worthy candidates for tax-loss sales: 20% of the assets in the category has flowed in during the past year, so many of these newly arrived investors are no doubt holding their positions at a loss. 

Individuals using the specific-share-identification method of cost-basis reporting can be surgical about tax-loss selling, pruning their highest-cost-basis positions and leaving their other holdings in the same securities intact. Precision selling is one reason I recommend that investors utilize the specific-share-identification method instead of their mutual fund company or brokerage firm's default method for cost basis. 

Who It Won't Benefit
Yet as profitable as tax-loss selling can be, it's not advisable in every situation. 

For starters, tax-loss selling can be a good idea in taxable accounts, but it's rarely advisable in an IRA, for reasons outlined in this article. 

And if you want to maintain a position in a specific security, you're better off staying put, as you can't repurchase within 30 days without potentially negating your tax loss via the wash-sale rule. If you wait at least 30 days to repurchase the same security, the holding could shoot up in the intervening time period, thereby offsetting the tax benefit of the loss. 

Moreover, the higher your tax bracket, the more you stand to gain from tax-loss selling, whereas those in the 0% capital gains bracket won't see a benefit. As financial-planning expert Michael Kitces argued in this blog post, individuals in the 0% bracket can benefit more from harvesting gains from their portfolios: They won't owe taxes at the time of the sale, and they can reset their cost basis to a higher level, thereby reducing their potential tax burden should they sell the security later and their capital gains tax bracket is no longer 0%.

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