Why Tax-Loss Selling Can Be a Worthwhile Strategy

Note: This article is part of Morningstar's November 2016 Year-End Tax-Planning Guide special report.

Jeremy Glaser: For Morningstar, I'm Jeremy Glaser. As 2016 comes to an end, many investors are looking for ways to lower their tax bill. I'm here with Christine Benz, our director of personal finance, to look at one such strategy.

Christine, thanks for joining me.

Christine Benz: Jeremy, great to be here.

Glaser: So, let's start with tax-loss selling. Is this something that investors should really bother with, because it sometimes seems like a lot of work?

Benz: Well, it does seem like a lot of work, but I do think it's a worthwhile strategy to pick through your portfolio, see if you have positions in your portfolio that are currently trading below what your cost basis is in the position. You can use those losses to offset capital gains in your portfolio, or if your losses exceed your capital gains, you can use them to offset up to $3,000 in ordinary income.

The reason why it's so valuable right now to look around for tax-loss sale candidates is that we have come through this period where a lot of positions have probably hit investors' sale targets. They maybe realizing gains this year, and even if they aren't actively realizing gains themselves, their funds may have realized gains and they may be making these capital gains distributions. So, it's worth taking a look at your portfolio to see whether you have any potential tax-loss sale candidates.

Glaser: And this is only for taxable accounts, right?

Benz: Well, technically, you can do tax-loss selling in your IRA accounts. It's usually not advisable because you have to liquidate all of your IRAs. And then if you want to fund the those IRAs in the future, you will be subject to the annual limits. So, it's generally not a great idea to take a look at your IRAs. Focus on those taxable accounts.

Glaser: You mentioned that we've had this multiyear run. How realistic is it that you are going to find a lot of positions that are under your cost basis and maybe some of those not in your cost basis have the potential to perform well? How do you identify the candidates for this?

Benz: So, two-part question there. The first part is, if you are a fund investor, you may not be able to find any losing positions. We've had this multiyear rally in equities. Every single diversified domestic equity category is in the black over the past three and five years. It's been a relatively good year so far in 2016. So, fund investors may find slim pickings. But if you're an investor who slices things a little more narrowly, you may be able to find some tax-loss candidates.

So, even if you are a fund investor, if you own some sort of Europe stock fund, you may find some depreciation there relative to your purchase price. Latin America equity, it's had a little bit of a recovery so far in 2016, but generally not a great category over the past few years. Precious metals equity, again, great performance so far in 2016, but negative performance over a multiyear period. And for investors who have done some buying more recently, specifically in the healthcare sector so far in 2016 or the energy sector within the past few years, even fund investors may be able to find some losing positions. You can also identify losing positions if you are using the specific share identification method for tracking your cost basis. So, you may be able to find within your holdings of a mutual fund some lots that you purchased at a higher level than perhaps where they are trading today. 

Stock investors have more latitude still to find losing positions. The reason is that individual companies respond a lot more to security-specific factors, company-specific factors. So, I did a quick screen yesterday, Jeremy, and found that there were about 120 companies that currently have 12-month losses of 10% or more, and these are large companies with market caps of over $25 billion. So, you don't have to venture into weird securities to find losing positions. If you are an individual stock investor, you may be able to find some specific holdings.

Glaser: But when you think of these funds, you think of these stocks that have sold off, those are often the bargains. How do you decide or why is it worth giving up the potential of appreciation there?

Benz: Yeah. So, that was the second part of your question. I think it's worth really weighing the investment merits of holding on to a position versus the tax merits of selling, because you are right, some of the depressed positions may be in a position to recover. One thing you want to look at though is, whether among some of your losing positions you can find a way to give your portfolio a little bit of an upgrade. So, we've seen this broad-based sell-off in the big pharma sector, for example, so far in 2016.

So, if you can't perhaps get out of that 3-star position and get into a position that our analysts rate as 4 or 5 stars. Or maybe you have some sort of energy sector fund, you want to maintain economic exposure there, perhaps you think it's still depressed and there's some upside, maybe you can swap out of the actively managed fund that's a bit overpriced and get into some sort of an energy sector ETF or index fund. So, I like the idea of giving the portfolio an investment upgrade, at the same time, you are perhaps improving your tax return for 2016.

Glaser: And if you do upgrade your portfolio with something similar, how do you know you're not going to run afoul of the wash-sale rule?

Benz: That's such an important point, Jeremy. Thank you for mentioning it. The wash-sale rule means that you can't buy the same security within 30 days of having sold it, otherwise you will disallow the tax loss that you were trying to harvest. So, you can't buy the identical security. You can't buy another share class of the same security, and you can't buy a security that in the IRS' eyes is substantially identical. So, that would mean that you can't take a losing position in an S&P 500 index fund and of course, you'd have to be awfully unlucky to have a losing position in an S&P 500 index fund, but you can't sell that index fund and buy an S&P 500 ETF, for example. That would be considered substantially identical. So, you need to be careful there. You can't maintain an almost identical position.

Glaser: Christine, thanks for joining me today.

Benz: Jeremy, great to be here.

Glaser: For Morningstar, I'm Jeremy Glaser. Thanks for watching.