Your Bay area House
The single biggest asset many people have is their home, and depending on the real estate market, a homeowner might realize a huge capital gain on a sale. The good news is that the tax code allows you to exclude some or all of such a gain from capital gains tax, as long as you meet three conditions:
You owned the home for a total of at least two years in the five-year period before the sale.
You used the home as your primary residence for a total of at least two years in that same five-year period.
You haven’t excluded the gain from another home sale in the two-year period before the sale.
If you meet these conditions, you can exclude up to $250,000 of your gain if you’re single, $500,000 if you’re married filing jointly.
Length of ownership matters
If you sell an asset after owning it for more than a year, any gain you have is a “long-term” capital gain. If you sell an asset you’ve owned for a year or less, though, it’s a “short-term” capital gain. And the tax bite from short-term gains is significantly larger than that from long-term gains.
“You pay a higher capital gains tax rate on investments you’ve held for less than a year, often 10 to 20 percent more, and sometimes even higher,” says Matt Becker, a financial planner and founder of Mom and Dad Money, LLC. That difference in tax treatment, Becker says, is one of the advantages a “buy-and-hold” investment strategy has over a strategy that involves frequent buying and selling, as in day trading.
Also, Becker notes that people in the lowest tax brackets usually don’t have to pay any tax on long-term capital gains. The difference between short and long term, then, can literally be the difference between taxes and no taxes.
Capital losses can offset capital gains
As anyone with much investment experience can tell you, things don’t always go up in value. They go down, too. If you sell something for less than its basis, you have a capital loss. Capital losses from investments — but not from the sale of personal property — can be used to offset capital gains. So if you have $50,000 in long-term gains from the sale of one stock, for example, but $20,000 in long-term losses from the sale of another, then you may only be taxed on $30,000 worth of long-term capital gains.
If capital losses exceed capital gains, you may be able to use the loss to offset up to $3,000 of other income. If you have more than $3,000 in capital losses, the excess can be carried forward to future years to offset income in those years.
Business Income is not capital gain
If you operate a business that buys and sells items, your gains from such sales will be considered — and taxed as — business income rather than capital gains. For example, many people buy items at antique stores and garage sales and then resell them in online auctions. Do this in a businesslike manner and with the intention of making a profit, and the IRS will view it as a business.
The money you pay out for items is a business expense, the money you receive is business revenue and the difference between them is treated as income, subject to the same taxes as income from employment.
THE LOSS HARVEST
Sell your losers and stay out for 31 days, then get back in. Harvest the deduction. What’s this strategy worth? A lot, but not nearly as much as some proponents claim.
Forbes can be counted as a booster of loss harvesting; these pages have promoted the strategy for at least 35 years. It works best when you can get in and out at no cost (with no-load funds) or at low cost (with stock trades at a discount broker). It pays, but not as well, when you run up management fees to have the work done for you.
Aperio and Parametric have been helping wealthy investors harvest losses for years. In 2011 Fidelity took semiautomated harvesting to the masses (fee: an incremental 0.3% a year for customers already paying for other investment management). More recently the robotic money managers Wealthfront and Betterment (both on the Forbes Fintech 50 list) have joined the ranks of harvest hustlers.
The robo-advisors offer bargain rates for portfolio management (0.15% to 0.35% a year). But be wary of the hyperbole.
A Betterment chart highlights a 1.9% potential annual benefit from the strategy over the period 2000-13. Wealthfront cites a possible 2% annual payout. Both vendors duly caveat their claims with discussions of why your results may differ.
The problem: To justify the big expectations you have to assume, rashly, that you can use any resulting short-term capital losses to offset high-taxed income.
You get that high-bracket offset against up to $3,000 a year of ordinary income. Nice, but that’s a meager sum for a wealthy investor. You also get to use harvested short-term losses in unlimited amounts against short-term gains popping up in other accounts. But why would you have those? Tax-wise investors don’t sell, impulsively, for a short-term gain.
Consider this possibility: Losses harvested from your securities will be put to use primarily to offset low-taxed long-term gains. If that’s the case, their boost to your net worth will be on the modest end of the advertised ranges.
Rational investors do often have long-term gains thrust upon them. These gains may arise from a mutual fund, from a home sale that is not fully protected by the $500,000 (per couple) exclusion or from a winning stock position swept away in an all-cash takeover.
Conclusion: You should harvest losses if you can do that with low transaction costs. You can expect to use most of them because they can be carried forward indefinitely. But you shouldn’t count on getting anything like two points of incremental return.