Did you hear that the New York Times released an unprecedented look at information contained in President Trump’s tax returns? I hadn’t read about it anywhere else, so figure I’d be the one to break this huge story for our audience.
Putting the jokes aside, along with any political posturing around the issues, the story does shine a light on a topic about which investment advisors should be fluent—tax loss harvesting. And before you rise up in the comments and scream at me that every advisor already knows about tax loss harvesting (most robos even automate part of the process at this point), keep in mind that your clients may not, and high-profile news situations like this one can present the perfect opportunity to educate clients on topics which might otherwise make their eyes glaze over.
First let’s address the elephant in the room. I have no idea how much of the information in the Times’ report is accurate and I know even less about the president’s highly complex financial situation, so I have no grounds to talk about any potential tax evasion here. However, there is a key difference between tax evasion and tax avoidance—the former is illegal; the latter should be considered a baseline service that advisors offer to their high-net-worth clients.
Tax loss harvesting is a powerful way to help clients legally minimize their tax burdens (tax avoidance). Under current U.S. tax law, it’s usually possible to offset your capital gains with capital losses you’ve incurred during that tax year or carried over from a prior tax return. In the case of the president, the alleged large tax credits he secured were largely the result of net operating losses from his real estate holdings, which are both not terribly applicable to non-billionaire clients and also subject to specific reporting rules, such as depreciation, that can further muddy the waters. That being said, most, if not all, clients presumably have some level exposure to securities where this technique can also come into play.
First, it's essential clients understand the difference between short- and long-term gains and losses. A short-term gain or loss is realized from a security held for one year or less before being sold, while anything held for over a year before sale would be considered a long-term loss.
As all advisors know, short-term capital gains are taxed as ordinary income, just like salary or wages. So, depending on what state your client resides in, this can result in them paying upwards of 50% on short-term capital gains between federal and state taxes. Long-term capital gains, on the other hand, are taxed as capital gain. For 2020, the maximum long-term capital gains rate is 20%.
These classifications matter because any losses your client seeks to harvest will offset their tax obligations like for like—short term losses offset short-term gains and the same for long-term. Any net short-term gain is then taxed as income and any net long-term gain is taxed using the special capital gains tax rates. So, short term losses are generally the more valuable of the two, as they’re used to offset gains that are taxed at the highest rates. Note that tax gains and losses only apply to regular, taxable investment accounts. Tax-deferred retirement account, such as 401(k) plans or IRAs are subject to different rules and not required to report such gains and losses to the IRS.
But it doesn’t end there. After offsetting other capital gains, the first $3,000 ($1,500 if married filing separately) your clients accumulate in capital losses offset ordinary income each year. And if that weren’t enough, any remaining losses can also be carried forward to future years. Because ordinary income is traditionally taxed at higher rates than long-term capital gains, as mentioned above, this carryover credit is even more valuable than it looks.
One of the main drawbacks of tax loss harvesting is that it tends to lower the overall cost basis of the assets in a portfolio, which can lead to higher capital gains on future sales and push things more into the realm of tax deferral than tax avoidance. This still represents an advantageous position based on potentially lower future tax rates and the time value of money, but its something to be aware of.
One potential, and more advanced, solution is to bring estate planning into the equation and take advantage of the “free” basis step up at death. Effectively, when you inherit an asset, your tax basis in that asset is equal to what it’s worth when you inherit it, not its original purchase value. So, by including low-basis assets in an estate (instead of gifting them or placing them in trust for example), next-gen clients can “reset” some of the negative effects of tax harvesting performed by the previous generation.
This is just the tip of the iceberg in terms of what’s possible with this technique, and I've certainly oversimplified things. Nonetheless, regardless of whether President Trump committed tax fraud or simply intelligently engaged in tax avoidance, his tax returns once again becoming national news represent an excellent opportunity for advisors to educate clients and themselves.
David H. Lenok is a Senior Editor with Wealthmanagement.com.
