Don’t Rule Out Tax-Loss Selling as 2023 Winds Down

The U.S. market gained more than 15% for the year to date through mid-November. That’s a healthy showing by any measure. It doesn’t seem like it would be a market environment that’s conducive to tax-loss selling.

But unless your strategy is to buy the whole market (or as Bogleheads say, “VTSAX and chill”), you may indeed have opportunities to realize tax losses in your portfolio, which you can use to offset gains elsewhere. That’s because a fairly small cluster of stocks has led the market’s upward trajectory, while other market segments haven’t performed nearly as well. That means that individual-stock investors or those who hold more finely tuned equity mutual funds or exchange-traded funds in their portfolios may find several positions that are selling below their cost basis, especially if they’ve made new purchases within the past few years. And in a twist from most years, when equities are the best candidates for tax-loss sales, bond investors may also have losing holdings in their portfolios if they look closely.

Must-Knows About Tax-Loss Selling

It’s important to note that tax-loss selling is only a worthwhile strategy if you have taxable accounts. If all of your holdings are in tax-sheltered retirement accounts, you can stop reading right now. You may technically be able to take a loss in your IRA, but that’s rarely a good idea because you’d need to liquidate your whole IRA and you’d be subject to annual contribution limits to build it back up.

To benefit from a tax loss that in turn can help you save on taxes, you need to find holdings in your taxable portfolio that are trading below your cost basis—your purchase price adjusted upward to account for any commissions that you paid along with reinvested dividend and capital gains distributions. You should be able to find your cost basis on your brokerage firm or fund company’s website. There are different methods for determining cost basis. The specific share identification method for cost-basis elections provides the most opportunities for tax-loss selling or gain harvesting because it allows you to cherry-pick specific lots of a security to sell. But it’s important to note that average cost basis is usually the cost-basis election default for mutual funds, while the default cost basis election for individual stocks is often first in first out. In other words, unless you select a different cost-basis election before selling, your investment firm will report your loss or gain using the default. (If you’ve already used the averaging method when you’ve sold a mutual fund, you’ll need to stick with it.)

If you sell securities and your sale price is lower than your cost basis, you have a capital loss. That loss, in turn, can help offset taxable gains elsewhere in your portfolio. (With many mutual funds again poised to make big capital gains distributions in 2023, those losses could come in handy.) If you don’t have any gains in the year you realize the losses or your losses exceed your gains, you can use the losses to offset up to $3,000 in ordinary income. Unused losses can be carried forward indefinitely and applied against future taxable gains.

Tax-Loss Sale Candidates Widespread

As 2023 winds down, here are some of the most fruitful spots to look for tax-loss candidates.

Bond Funds and ETFs, Newly Purchased Individual Bond Positions: Owing to recent increases in interest rates, which depress bond prices, investors in search of tax-loss sale candidates may find even more opportunities among their fixed-income holdings than in their equity positions today. Long-term bonds and bond funds look especially ripe for tax-loss selling: The typical long-term bond mutual fund has lost 9% on an annualized basis over the past three years, and long government funds have lost 15%, on average, over the same period. While losses in intermediate-term bonds haven’t been as deep, there are still plenty to be had: The typical intermediate government bond and intermediate core bond funds have posted 5% annualized losses over the past three years. Moreover, tax-loss selling may provide a hook to improve your total portfolio’s asset location, in that fixed-income holdings are often best situated in tax-sheltered accounts rather than taxable ones. With yields surging, being smart about asset placement now matters more than it did when yields were exceptionally low.

Individual Stocks: Individual stock investors obviously have the easiest pickings when it comes to unearthing tax-loss sales. Even if your portfolio has performed well in aggregate, it’s likely that something you own has lost value since you purchased it. For the year to date through mid-November, about 2,800 U.S. stocks with market caps of more than $100 million had losses of 10% or more. You may even be seeing red on positions you’ve owned for a while: Roughly 1,900 individual U.S. companies with market caps of more than $100 million had 10% or greater losses over the past three years. Losses in the energy, utilities, and real estate sectors have been particularly widespread. Healthcare stocks have been weak for the year to date, too.

Non-U.S. Stock Funds: While many broadly diversified non-U.S. stock funds have recovered after a weak showing in 2022, a handful of non-U.S. equity fund categories are sitting on decent losses over the trailing one- and three-year periods. Asian stocks and the funds that own them, especially Chinese equities, have been particularly weak: The China region, diversified Pacific/Asia, and Pacific/Asia ex-Japan stock Morningstar Categories all had meaningful losses over the trailing three-year period.

Sector Funds: Investors who own sector-specific funds or ETFs may also find tax-loss sale candidates. The equity precious-metals category has posted an average loss of 11%, the worst result of any sector-fund group over the past three years, and losses have persisted into this year, too. Utilities have also shed value thanks to rising interest rates. Healthcare stocks have also struggled so far in 2023; the typical fund in the group is down nearly 9% for the year to date.

Next Steps

If you sell a security for a loss, you can go ahead and replace it with something similar right away, provided the new holding isn’t so close that the IRS considers it “substantially identical.” Immediately replacing an actively managed fund with an index fund or ETF would be just fine, for example. But swapping an index fund for an ETF that tracks that same index would run afoul of the wash-sale rule, in that they’re substantially identical securities. In that instance, the IRS would disallow the loss. And if you wait 30 days after selling the losing security, you can replace it with the very same security and still claim the loss.

However, I like the idea of tying tax-loss selling along with a broader portfolio review and cleanup effort. You can address asset location issues, as I mentioned in the context of bond funds. Alternatively, you could switch into a portfolio mix that’s more hands-off and has fewer moving parts—for example, a compact portfolio of broadly diversified stock and bond index funds. Such a portfolio might yield fewer tax-loss opportunities going forward, but it’s apt to be lower-maintenance and quite tax-efficient on an ongoing basis.