Time Value of Capital Losses

The bottom line

• Accumulating capital losses via systematic tax-loss harvesting in anticipation of future gains can serve as an insurance policy against future gain recognition events, providing enhanced flexibility to achieve future goals with minimal tax consequences.
• Long-only direct indexing portfolio may offer great loss harvesting opportunities. Tax-managed public equity long/short portfolio may further enhance loss-harvesting opportunities while adhering to an investor’s pretax investment thesis.
• Tax-loss harvesting may not be suitable for all investors and advisors should help clients determine its potential benefits and downsides based on their unique situations.

For many investors, systematic tax-loss harvesting may significantly reduce an investor’s tax burden and improve after-tax returns, especially when paired with active strategies that generate capital gains.

However, gain recognition events can take many forms, and countless investors without regular capital gains may still need to realize gains periodically. For example, gains may be realized when maintaining asset allocation targets, repositioning a portfolio, or during significant liquidity events like the sale of a business or rental property.

Forecasting future capital gains can be challenging, but accumulating capital losses in anticipation of future gains can serve as an insurance policy against future gain recognition events, providing enhanced flexibility to achieve future goals with minimal tax consequences.

Although the benefits of tax-loss harvesting are deferred until there are gains to offset, collecting losses over multiple years may allow an investor to offset more gains than if the program starts in the year of the taxation event.

Due to the risk characteristics of underlying investments, a long-only direct indexing portfolio may offer greater loss harvesting opportunities than bonds, equity mutual funds, or equity ETFs. Relaxing long-only constraints and introducing margin and shorting to create a tax-managed public equity long/short portfolio may further enhance loss-harvesting opportunities while adhering to an investor’s pretax investment thesis.

In their article, Lincoln and Taotao explore the significant tax benefits of strategies like loss-harvesting in anticipation of future gains and employing a tax-managed long/short public equity portfolio, while also examining potential tradeoffs and situations when such strategies should be avoided.

For advisors seeking to learn more, Lincoln and Taotao’s article is a must-read. Please find the full reprint by clicking here.

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