Don't Write Off Tax-Loss Selling in a Strong Market
Even buy-and-hold investors may be able to identify worthy candidates.
Note: This article is part of Morningstar's November 2016 Year-End Tax-Planning Guide special report. A version of this article appeared Sept. 10, 2015.
Investors are often encouraged to scout around for tax-loss sale candidates as a calendar year winds down. By selling securities that are trading for less than they paid for them, they can net tax losses that they can use to offset capital gains and, if they still have excess losses, up to $3,000 in ordinary income.
But for some investors, that advice rings a little hollow. On many household balance sheets, taxable accounts--typically the only account type where it makes sense to engage in tax-loss selling--are but a small piece of the overall pie. Investors' IRAs and 401(k)s are where the real money is, but tax-loss selling from those accounts rarely makes sense, as discussed here.
Moreover, many investors use their taxable assets to fund near- and intermediate-term goals--to purchase cars and stash money for tuition, for example. That makes it more likely that they're using bonds and cash to fund those goals, not stocks, and so they're less likely to own good tax-loss candidates there, period. High-quality bonds don't exhibit the same price volatility that equities do, so pruning them for tax losses won't often make sense.
Finally, there's the strong market environment that has prevailed, with just a few interruptions, since early 2009. Bonds of various types have performed decently, too. Because of the breadth of the current rally, the segment of investors who do hold sizable taxable accounts with sizable equity positions may have trouble locating good tax-loss candidates, especially if they're primarily fund investors. All but a tiny handful of mutual fund categories have positive returns over the past five years; the few losing categories that there are hail from niche categories that appear in few investors' portfolios, such as bear-market and Latin America stock funds.
Yet, investors shouldn't necessarily write off the whole endeavor. Tax-loss selling may still make sense in certain instances.
Tax-Loss Selling for Fund Investors
As noted above, many fund investors might not be able to identify worthy tax-loss candidates, especially if they don't trade frequently and they're averaging their cost basis rather than using the specific-share-identification method. (The differences in cost-basis methods are outlined here.) They probably have gains, rather than losses, in their holdings over their holding periods.
Fund investors using the specific-share-identification method for cost basis may be able to find an even greater array of worthy tax-loss candidates, however, as recent additions in certain categories may well be trading below their cost basis. Various foreign-stock fund categories have lost ground so far in 2016, for example, and the equity precious metals and real estate categories have taken a powder recently, too.
Tax-Loss Selling for Stock Investors
Stock investors using the specific-share-identification method also have quite a bit of latitude to unearth worthy tax-loss candidates, especially among their most recent additions. More than half of the U.S. stocks in Morningstar's database have declined in value during the past one- and three-year periods. Of course, many of these are flaky, fly-by-night companies that appear in few investors' portfolios. But 201 individual stocks with market values of more than $25 billion are selling below their price from three years ago, and 75 are in negative territory during the five-year period.
Beware the Wash-Sale Rule
The hitch with tax-loss selling is that you might expect some of these funds and stocks to recover. That means that even if selling makes sense from a tax standpoint, it may not add up from a big-picture returns standpoint.
Unfortunately, it's not as simple as selling a security, booking a tax loss, and then rebuying the same security immediately thereafter. Purchasing the same or what the IRS calls "a substantially identical" security within 30 days of selling it would trigger what's called the wash-sale rule and would disqualify you from claiming the tax loss.
Fund investors have quite a bit of latitude to circumvent the wash-sale rule, however, in that they can sell a laggard and swap into another offering that gives them similar exposure. While selling an emerging-markets index fund and buying an emerging-markets ETF would probably run afoul of the wash-sale rule, selling an emerging-markets index fund and buying an actively managed one (or vice versa) should pass muster. Tax-loss selling may also provide an opportunity to swap out of an investment type that, in hindsight, wasn't a great fit for you. For example, you may decide that you didn't need a region-specific Latin America stock fund and that a broad emerging-markets fund is a better idea.
For stock investors who want to sell out of a stock that's trading below their purchase price while maintaining similar economic exposure, Morningstar's Premium Stock Screener can help identify highly rated securities in the same industry as the tax-loss sale.
Christine Benz does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.