Guidance

RESOURCES TO HELP SHAPE YOUR FINANCIAL FUTURE

In difficult times like the one we are all living through, it pays to be sober and realistic but to look for the silver linings wherever you can find them.

For investors, tax-loss selling nicely ties those themes together. The starting point is the sober realist component: acknowledging that some of the holdings in your taxable account could have dropped in price since you purchased them. The silver-lining aspect is that taking stock of those losses could help reduce your tax bill, for 2020 and possibly into the future.

Even if stocks end on a down note this year, it is possible that mutual funds will be making big capital gains distributions again, the result of ongoing redemptions and years of embedded gains on their books. And any capital losses that you do not employ to offset capital gains can be used to offset ordinary income or carried forward into the future, when you will likely have gains again.

Surgical Is Best
That is the why of tax-loss selling. As for where to look for potential candidates, your taxable accounts should be your first, and very likely last, stop. While it is technically possible to realize a loss in an IRA, it is not usually advisable.
Securities in a taxable portfolio that are trading below your cost basis—the amount you paid for your shares plus commissions you paid and reinvested dividend and capital gains distributions—are prime targets for tax-loss selling. (Other corporate actions, such as stock splits, can also affect your cost basis.)

When it comes to identifying specific securities to sell, it pays to take a surgical approach. If you have narrowly focused holdings in your portfolio—say, individual stocks or sector funds or exchange-traded funds—you are in the catbird’s seat with respect to tax-loss selling. You can trim your losing-est holdings without bothering the securities in your portfolio that have appreciated since you bought them. On the other hand, if your portfolio features broadly diversified funds rather than more finely tuned holdings, you will also need to be surgical when identifying tax-loss sale candidates—but in a different way. Because the current market slide follows a decade’s worth of strong gains for the market at large, your average cost basis in broadly diversified funds may still be below your holdings’ current net asset values; selling would trigger a gain, not a loss.

That means that your best shot at finding tax-loss sale candidates will be to cherry-pick specific lots of securities to sell—those with the highest cost basis that are most likely to result in a tax loss. That is called the specific share identification method of cost basis, and it is especially valuable at times like this. Right now, for example, someone using the specific share identification method might unload high-cost shares purchased in 2019 or even earlier this year, before the market started to slide, while leaving lower-cost-basis shares in place.

The average method, whereby all of your purchase prices are averaged together, is usually the default cost-basis method for mutual funds, though if you have not used the averaging method on a sale before you can override it by changing your cost basis election on your provider’s website. The averaging method is simple and clean, but it obviously does not allow for surgical tax-loss harvesting in the way that specific share identification does. And it is important to note that if you have sold shares using the averaging method in the past, you will have to stick with it in the future.

Where Stock Investors Can Look
Investors in individual stocks are the most likely to be able to identify tax-loss candidates at this juncture, simply because it is more likely they would have outlier performers even though the broad market has trended up for the better part of a decade.

As of April 2, 2020, 156 U.S.-listed large-cap stocks had annualized losses of more than 10% over the past five years. Roughly a fourth of those names landed in the financials sector; banks were especially prominent. But the losing holdings were scattered far and wide across many different industries.

Note that most of the stocks with sizable annualized losses have non-U.S. headquarters.: All but six of the 156 companies that were in the red over the past five years were domiciled outside the United States. Most are ADRs.

Equity investors who made individual-stock purchases more recently will likely have even more tax-loss sale candidates to choose from in their portfolios. While technology and healthcare stocks have performed better than the broad market thus far in 2020’s rout, most stocks have double-digit losses over the past year, regardless of sector.

Where Mutual Fund/ETF Investors Can Look
As noted above, mutual fund and exchange-traded fund investors with more finely tuned positions—sector- and region-specific ETFs, for example—will have an easier time finding holdings to prune. Over the past three-, five-, and even 10-year periods, natural resources and commodities funds have posted annualized losses, so they are a good first stop for people who own them.

Among broadly diversified funds, small- and mid-cap value funds have been hard-hit over the past three- and five-year periods. The typical small-value fund, for example, has lost about 11% on an annualized basis over the past three years. And as noted above, investors who are using the specific share identification method or recently initiated positions in funds or ETFs may be able to unload recently purchased shares at a loss, as nearly all equity funds are in the red so far this year.

Do Not Miss the Forest
If you are taking tax losses in this market, bear in mind that the areas that look ripe for pruning may also represent a good buying opportunity. Per Morningstar analysts’ bottom-up research, stocks in the energy and financials sectors are trading at sizeable discounts to fair value, though most of those discounts are also accompanied by high fair value uncertainty ratings.

If you would like to maintain economic exposure to the same part of the market that you are selling out of, you need to get familiar with the wash-sale rule, which states that buying a “substantially identical” security to the one that you have sold within 30 days of the sale negates your ability to take a tax loss on the sale. For example, you could not sell a fund tracking the MSCI EAFE Index and buy an MSCI EAFE-tracking ETF right away instead. You could not swap one share class of a stock for another. But you could sell an actively managed foreign stock fund and buy a foreign stock ETF.

 

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