In down years like 2022, tax-wise investors will often take the opportunity to execute “tax-loss harvesting” opportunities. This is a topic we talked about last year (and many times prior). For those needing to get caught up on the idea, in brief, this means that you sell securities that have an unrealized capital loss. In doing so, you can realize these losses and thus potentially reduce your tax bill for that year. In most cases, you use the proceeds from the sale and immediately purchase a different security, so that you can maintain exposure to the market as it recovers. There’s more to it, but let’s keep it simple and instead move on to our topic for today.
For those of you who did harvest losses in 2022 (whether we did this for you, or you did it on your own), you should have seen these losses reported on your brokerage Form 1099-B issued earlier this year. What do you then do with them, and what’s that “carryforward” that your accountant or TurboTax is now talking about as you finish up your 2022 tax return? Let’s explore.
Sample “Summary of 2022 Proceeds from Broker and Barter Exchange Transactions” (Form 1099-B / Fidelity). Note that this is a sample only and the numbers shown herein are not utilized in the examples below.
When you realize losses, the first thing you do is use them to offset any realized gains. If your losses exceed your (realized) gains for the year, you have a net loss – and potentially a carryforward. Let’s look at three simple examples:
EXAMPLE 1 – Net gain
You realize $30,000 in long-term capital gains from selling a long-held position in Apple. In the same year, you realize a total of $25,000 in long-term capital losses from a variety of positions that were underwater. In this case, you simply net out these two amounts, leaving you with a $5,000 net long-term capital gain for the year. This is added to your Adjusted Gross Income (AGI) and taxed at favorable capital gains tax rates (15-23.8%), depending on your income). You have no further tax burden or carryforward to deal with in future years.
EXAMPLE 2 - $0 gain
You realize $30,000 in long-term capital gains from selling a long-held position in Apple. In the same year, you realize a total of $30,000 in long-term capital losses from a variety of positions that were underwater. In this case, you simply net out these two amounts, leaving you with $0 in capital gains for the year. While you report these gains and losses on your tax return, the fact that they net to $0 means you have no tax liability related to them for the year (or in future years).
EXAMPLE 3 - $10,000 net loss (Here’s where it gets interesting)
You realize $30,000 in long-term capital gains from selling a long-held position in Apple. In the same year, you realize a total of $45,000 in long-term capital losses from a variety of positions that were underwater. In this case, you simply net out these two amounts, leaving you with a $15,000 net long-term capital loss for the year. Since you don’t pay taxes on losses, what do you do?
- You deduct $3,000 of this $15,000 against your ordinary income. This is a fixed dollar amount allowed by the IRS. This brings down your AGI and your net taxable income, reducing your tax bill by anywhere from 10-37% ($300-1,110), depending on your marginal tax bracket.
- You then carry forward the remaining $12,000 for use in future years. Let’s look now at how you would use this in future years.
What to do with that carryforward?
First, keep good records of it. The IRS isn’t going to send you a reminder that you have an available deduction in future years, nor will this show up on your Form 1099 from Fidelity, Schwab, etc. in future years, it is your responsibility to track it and utilize it. How do you utilize it in future years? As is often the case, the answer is “it depends.” Let’s look at the two ways. In both cases, we are going to assume the carryforward is from tax year 2022.
You can use it to offset gains realized in 2023. Let’s say you realize $12,000 in long-term gains in 2023. You would then use the $12,000 carryforward loss to completely offset your 2023 gains, bringing your capital gains taxes to $0.
Let’s now look at a slightly more complicated, but illustrative, example. Here we’ll assume your realized gains in 2023 are $5,000. What would you do here?
- You would first use a portion ($5,000) of your carryforward to completely offset your current year gains. This would leave you with a $7,000 balance on your carryforward. What do you do with this?
- You would then reduce your ordinary income by $3,000, just as you did in Example 3 earlier. So, you effectively use $8,000 of your carryforward in 2023. This would leave you with a $4,000 balance on your carryforward. What do you do with this?
- You would then carry forward the $4,000 balance and utilize it in 2024. Rinse and repeat!
Here are a few other important things to keep in mind:
- You can carry forward losses indefinitely. If you had a very substantial net loss in 2022 and minimal realized gains in future years, your loss could carry forward for many years. With each passing year, you would at least use up the $3,000 deduction against ordinary income, slowly chipping away at this asset known as your carryforward balance.
- We have only looked at long-term gains and losses here, for the sake of simplicity and brevity. It gets slightly more complicated when you start layering in short-term gains and losses, which are taxed differently than long-term gains. We are happy to provide guidance specific to your circumstances if short-term gains and losses are part of your picture.
- You have to realize gains and losses for them to enter into your tax picture. “Realize” means “sell.” If you simply hold your asset, the gains or losses remain “unrealized” and are not taxable.
- Taxation considerations related to capital gains and losses only apply to non-retirement accounts. Gains and losses realized within qualified retirement accounts (e.g. 401(k), IRA, Roth IRA, etc) are not taxable, nor can they be used to offset gains from non-retirement accounts.
We hope this helps. As always, we welcome your questions. Thinking about taxes is a key element to what we do here, as doing so is a key part of ensuring the success of your financial plan.