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Practice Wise: Using the Turmoil to Your Clients' Advantage--Tax-Loss Harvesting

The market has created tax-saving opportunities for clients.

Editor’s note: Read the latest on how the coronavirus is rattling the markets and what investors can do to navigate it.

This article was originally published in Morningstar Office.

There is nothing pleasant about the current stock market collapse and the coronavirus epidemic. At the same time, even as clients are experiencing a sea of red in their stock portfolios, there’s a real opportunity for advisors to gather tax benefits through tax-loss harvesting.

During this crisis, in addition to helping our clients stay focused on their strategy to meet their goals, probably the next-biggest added value we can bring is tax-loss harvesting. I’m not just talking about year-end; tax-loss harvesting should be done throughout the year--especially now.

The recent market volatility has been extreme, so this has created huge tax-savings opportunities. Using our rebalancing software, we were able to identify each day in which clients needed rebalancing and which accounts held positions that could benefit from tax-loss harvesting.

From Feb. 3 through March 9, 2020, we completed over 200 trades, of which 116 were tax loss trades, producing tax losses of about $800,000 with tax benefits estimated at about $220,000. The total time to determine which accounts to trade and to calculate, review, and submit trades was approximately 50 hours over the entire time period. On March 11, 2020, we harvested almost $500,000 of losses for 55 clients. Total time? About two hours.

This particular cycle is not a brand-new experience. In fact, the current market reminds me of the global financial crisis in 2008.

During that time, I was religious about harvesting tax losses. At the end of the year, if the average client’s portfolio was down by 30%, we had harvested losses equivalent to 60% to 90%. It seems impossible, but depending on clients’ actual tax basis and the extent of volatility, it is actually a simple matter to gather up more in losses than the net annual decline.

Without rebalancing software, trying to harvest losses opportunistically throughout the year can seem like more work than it’s worth. But in addition to the benefit to your clients, don’t forget that your robo competition is harvesting losses daily.

(Important disclosure: My firm created the Total Rebalance Expert software platform which we sold to Morningstar. See the end of this piece for my full disclaimer.)

Here’s an example. Let’s say your client holds Mutual Fund A with a cost basis of $100,000 that drops to a value of $90,000. You harvest the $10,000 loss and replace the holding with Mutual Fund B. Two weeks later, Mutual Fund B is worth $85,000. You harvest the $5,000 loss and replace the holding with Mutual Fund C. Three weeks later, Mutual Fund C is worth $82,000. You harvest this $3,000 loss and buy back into Mutual Fund A.

By the end of the year, Mutual Fund A has almost recovered completely and is now worth $97,000. Thus, the value of Mutual Fund A declined by 3% during the year. Yet, you harvested losses totaling $18,000--or 18%. Assuming a capital gain tax benefit of 20%, the tax benefit from tax-loss harvesting of $3,600 more than offset the 3% decline.

How We Harvest Tax Losses
Even if you don’t have rebalancing software, there are ways to simplify the process by focusing on only the most substantial opportunities. Identify which positions have the largest declines and work on harvesting those positions for clients holding a significant amount. You won’t be able to do as many transactions as an advisor using software, but you will at least be capturing the largest opportunities.

But managing tax-loss harvesting requires adherence to some rules. These are important parameters because attempting tax-loss harvesting transactions too frequently can result in lost opportunities or wash sales.

If we planned to process tax-loss harvesting trades daily, we’d need to identify at least 30 alternative funds (or positions) for each investment. Since that’s not practical, we limit our tax-loss harvesting transactions to material amounts and no more than a few times per month. This way, we need only identify two alternative holdings.

Your specific parameters can vary based on your capacity, but here’s ours.

Tax losses should be recognized only when:

1. The loss is material. The minimum loss required can be based on client preferences, advisor judgment, and the advisor’s capacity for producing transactions. Typically, materiality is expressed as a fixed dollar amount or a percentage of the client’s portfolio. Because even short-term losses will likely eventually offset long-term gains, the tax benefit should be calculated based on the long-term capital gain rate, currently up to 20%. At my firm, $2,500 is a minimum loss.

2. The percentage loss is material. The percentage loss should be significant to ensure that daily price fluctuation doesn’t turn a planned loss transaction into a gain. Depending on the security type and market volatility, a 3%-10% loss minimum should be required for tax-loss harvesting. We’re currently using 4% as our minimum percentage.

3. An appropriate replacement fund exists. At my firm, if we can’t identify a suitable replacement fund for a position, then we don’t harvest tax losses in that case. We don’t want to compromise long-term investment strategy for temporary tax savings.

As we know, tax losses are disallowed if the same or a “substantially identical” position is bought within 30 days of the sale. So, to avoid being out of the market during the 30-day wash sale period, it is important to substitute a replacement position to keep clients fully invested (rather than go to cash for 30 days). Since the replacement fund might appreciate, it must be appropriate for long-term holding.

With the recent market volatility, we’ve added additional alternative holdings because we’re more likely to be doing repeat rounds of harvesting. Rather than try to identify “boutique” fund managers requiring deep dive research, we’ve chosen to add Vanguard or DFA index funds to our list of alternative holdings.

4. The value of the tax savings is significant compared with transaction costs. Finally, the tax savings should be significant compared with the costs of the transaction. A good rule of thumb is that the savings must be at least eight times the cost.

We have trained our clients to expect downturns. They are also aware that during these times, we rebalance (buy bargains) and harvest tax losses. When a drop occurs, we usually only hear from our clients if they don’t see trade confirmations.

Tax-loss harvesting is just one of the many ways advisors can add value with tax-efficient portfolio management. Advisors who are not doing this are depriving their clients of significant tax benefits.

Sheryl Rowling, CPA, is head of rebalancing solutions with Morningstar and principal of Rowling & Associates, an investment advisory firm. She is a part-time columnist and consultant on advisor-focused products for Morningstar, and she continues to actively run her advisory business, from which Morningstar acquired the Total Rebalance Expert software platform in 2015. The opinions expressed in her work are her own and do not necessarily reflect the views of Morningstar.