I’ve written before about tax loss harvesting. It’s a pretty simple concept: if you lose money on an investment, you qualify for a tax deduction, and a tax deduction saves you money. It makes intuitive sense, and it’s beneficial to lock in losses during bad years in the stock market, or to offset gains.
I’d also read about something called tax gain harvesting, but this made no sense to me. It involves selling investments that have appreciated then immediately rebuying them. But if you sell investments for a gain, you owe the government capital gains tax. It’s fine if you sell investments because you need the money, but why would you just sell investments to rebuy them? This is like harvesting a tomato then trying to glue it back to the vine, isn’t it?
Actually, it’s not. I’ve looked closer into the issue, and I think I finally understand why someone would want to sell an investment for a gain. It’s not for everyone, but if the financial stars align just right, there could be big benefits to harvesting gains. But before I explain why, let’s make sure we have a clear understanding of capital gains taxes.
When you sell an investment that you purchased in the past, you either gain or lose money based on what you originally paid for it. If you buy a single share of Microsoft stock for $50 per share, then sell it for $51 a few years later, you have just made $1 in capital gains. This gain may be subject to taxation based on your tax bracket. If, instead, you sell the stock for $49, you have just generated a loss of $1, which you can deduct from your federal income taxes.
A tax gain harvester sells an appreciated investment and quickly repurchases it at a higher cost basis. They’re creating a taxable event on purpose. Why?
Because at this point in time (late March of 2015), not everyone has to pay capital gains tax. If you’re a married couple filing jointly and you make under $74,900, you pay 0% in capital gains on sold investments. Since you will not owe any money on the transaction, selling for a gain then rebuying essentially sets you at a higher cost basis. If the time comes that you need to sell the investment in the future, you’ll pay less tax than before, regardless of your tax bracket. And if the market falls, you’re in a better position to harvest losses as well.
In short, tax gain harvesting is a gift to your future self. And because it works best when income is low, it can act as a rare bright spot during a bleak time. Say, during a layoff, when income drops for a year.
Note that this only works for regular taxable brokerage accounts. Your retirement accounts such as 401(k)s and IRAs do not incur taxes until you sell the investments in retirement, so you can’t harvest gains or losses in them. But that’s the only rule to worry about if you’re harvesting gains.
Tax loss harvesters have to worry about this pesky rule called a wash sale. If they rebuy shares similar to those they sold for a loss, the IRS can take away their tax deductions. This can be difficult to avoid, especially if they have automatic investments in various places. How do you know that your 401(k) contribution didn’t accidentally wash out that strategic stock sale?
Fortunately there is no wash sale rule for harvesting gains, because it’s not thought of as a benefit to sell at a gain. But it can be, and you’re only hurting your future self to ignore the opportunity.