SRRTF - Tax Loss Harvesting - How To Take Advantage

2023-12-23 08:00:00 ET

Summary

• Tax loss harvesting allows for the deferral of taxation and, with the right tactics, the conversion of deferred taxation into permanent gains.
• One can benefit from other traders harvesting tax losses by spotting opportunities in stocks that have become cheap due to disproportionate selling activity.
• Market movement caused by tax loss harvesting can create opportunities to buy stocks at a lower price and potentially see a rebound in the new year.

'Tis the season to be jolly, but it is also the season to harvest tax losses.

There are 3 key aspects of tax loss harvesting:

1. How to use it to defer taxation
2. How to convert deferred taxation into permanent gains
3. How to benefit from other traders harvesting tax losses.

This article will examine the mechanics of tax loss harvesting and then move on to spotting opportunities created by the disproportionate selling activity which has made a select group of stocks quite cheap.

The Basics

A diversified portfolio is usually going to have some stocks that have gone up and some that have gone down, which means one is often sitting on both unrealized losses and unrealized gains.

Taxes are paid based on realized gains taken during a calendar year. If someone has sold some winners during the year, they will probably be sitting on a realized gain, which will become taxable if it goes unwashed.

These gains can be washed by selling shares of stocks with an unrealized loss. The selling converts the unrealized loss into a realized loss, which can then be used to mitigate the realized gains.

Wash sale rule

A transaction producing a realized loss can only be used to wash gains if it is not bought within a 30-day window before or after the sale.

So if someone sells a stock for a tax loss on December 20th, they must not have bought that stock in the 30 days before and must refrain from buying that stock in the 30 days after.

One can use the proceeds of the sale to buy a stock in the same sector. For example, if one sells Exxon Mobil (XOM) for a tax loss, they can immediately put the proceeds into Chevron (CVX) and still use the loss to wash gains. They simply cannot buy back the exact same security or one that is considered identical.

Benefits of tax loss harvesting

The net effect of tax loss harvesting is to keep gains in the unrealized bucket instead of the realized bucket. Thus, taxes are merely delayed rather than avoided. When the gains are eventually realized, they will still trigger taxation.

That said, there are many ways to convert the deferral into a permanent gain.

1. Timing of gain realization
2. Indefinite deferral
3. Compounding of gains

Through tax loss harvesting, one can time their taxable gain realization to whatever is optimal for their individual situation. Capital gains are taxed at different rates depending on one's tax bracket. Here are the rates for long-term capital gains.

One could tax loss harvest in a year where they are in a high tax bracket, and then later take their gains in a year in which they are in a lower tax bracket. Retirement might be a reason to do this.

While working any ordinary income taxable gains from stock would be at their full-time employment tax bracket but upon retiring they are possibly at a lower tax bracket allowing the gains to then be taxed at a lower rate.

Indefinite deferral

While deferred gains will eventually be taxed when the gains are realized, investors have the option to simply not realize them. One can hold on to their winners indefinitely.

It may not always be wise to do so, but if the company remains fundamentally sound and the investment remains opportunistic, holding onto the winner can potentially be better than realizing the gains.

Compounding

For the sake of illustration, let's say one uses tax loss harvesting to defer taxation of a magnitude of gains that would result in a tax bill of $10,000. Even if they realize the gain the following year, and thus still pay the $10,000, they will have a full year of extra time to grow that capital. Whatever return is generated on the $10,000 would represent a permanent gain that would endure even after the deferred taxes are eventually paid.

Legal and ethical

There are many tax loss harvesting tactics one can use. The above represents just a small sampling of the possibilities. These tactics are entirely legal and considered proper actions for professional investors as well as individuals. We at 2nd Market Capital frequently use tax loss harvesting to help our advisory clients save on their tax bills.

Market movement caused by tax loss harvesting

There is often a reversal in stock price movements in January. I think it will be particularly pronounced this year due to the strong stock market.

With the S&P up this much, market participants are likely sitting on massive gains.

The stocks that have done well throughout the year will tend to be buoyant in the closing months of the year because even those who want to sell do not want to take the gain in the current calendar year and would therefore tend to wait until January to sell. As a result, the big winners of the previous year often experience a downdraft in the new year.

The strong 2023 also is likely causing weak performance in the later months of the year for stocks that have been down. Due to the strong year, there are a lot of gains that need to be washed, and only a small percentage of stocks that are down enough with which to wash those gains. Thus, a large number of tax loss harvesting transactions get funneled into a small number of stocks, causing a rather substantial headwind to stock prices toward the end of the year. This also tends to reverse in the new year, with the price rebounding as market participants wait out the 30-day wash sale rule and then buy them back.

Market movement of this nature is particularly opportunistic because it is not related to fundamentals. It creates an interesting situation in which investors are selling off stocks that they actually like and want to own.

The stock prices become out of sync with fair value.

Stocks that have been sold off due to tax loss selling, which I believe will rebound in 2024.

There are dozens of stocks that are opportunistic due to tax loss harvesting sell-offs, but I will highlight 3 in particular, as I think they show the cleanest examples of the concept.

W. P. Carey (WPC) traded down substantially in 2023 due to investors disliking the spinoff.

The initial move down happened on company-specific news, but the fact that it performed so poorly made it a great candidate for tax loss harvesting later in the year. I suspect it will rebound in early 2024 as the wash sale time period lapses.

Slate Grocery REIT (SRRTF) is in a particularly unusual situation as it has had an endless flow of good fundamental news, yet its price is down materially.

These small issues tend to have a bit more erratic price movements, so I think it was down early in the year just on noise, but then those losses picked up momentum as it became a candidate for tax loss sales. Shopping centers in general are opportunistic right now due to favorable leasing dynamics and SRRTF is on sale. I think it will swiftly rebound in 2024.

Prices can be distorted upward too, which is what I think happened with Park Hotels & Resorts (PK)

Notice the surge in the chart above to close out the year. With a stock up as much as PK, investors don't want to sell in November or December only to immediately pay taxes on their gain.

In a market bereft of sellers, the stock is floating upward as we approach the end of the year. Hotel fundamentals are not anywhere near strong enough to justify this sort of momentum. I think it will drop when 2024 hits. Note that because this was a deferral of selling rather than tax loss harvesting, it is not subject to the 30-day wash sale rule. People can sell right away on January 1st if deferral of gains was their primary motivation for keeping the stock.

Wrapping it up

It may be worth executing some tax loss harvesting if you are sitting on a realized gain. Most of the benefits here are quite specific to the individual, so there is no one-size-fits-all approach. Take a look at your individual situation and give it some thought.

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