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Make sure year-end tax loss is not a bitter harvest

As the year-end approaches, tax-loss harvesting becomes all the rage. But for many investors, the benefits are rather dubious.

Chris Bolin/chris bolin The Globe and Mail

As the year-end approaches, tax-loss harvesting becomes all the rage. But for many investors, the benefits are rather dubious, according to academics such as Kent Smetters, a professor at the Wharton School of the University of Pennsylvania.

Tax-loss harvesting occurs when a long-term investment is showing a loss in a taxable account. It is sold and replaced with a highly correlated investment or the same investment after the 30-day superficial loss rule. A capital loss is then reported and taxes reduced for the year.

However, the taxes are only deferred. That's because tax-loss selling re-sets the entry price lower. When the investment position recovers as expected and is sold, there is a bigger capital gain on which to pay taxes, which offsets the harvesting gain. This can be illustrated through an example.

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In the baseline scenario, an investor puts $10,000 into a fund. It declines to $7,000, and then rises over the years to $14,000, where it is sold. An investor in the 33-per-cent tax bracket holds throughout and pays capital-gains taxes of $660 ($4,000/2 x 0.33) at the end.

In the tax-loss selling scenario, an investor sells at $7,000 and repurchases the investment after 30 days at $7,000 (for the sake of simplicity). The capital loss generates tax savings of $495 ($3,000/2 x 0.33). The investment then moves up to $14,000 and is sold, incurring taxes of $1,155 ($7,000/2 x 0.33). Netting out the harvesting gain, final taxes are $660 – same as the baseline scenario.

Some people are aware of the tax equivalency yet still believe harvesting is worthwhile. It's better to take the tax-harvested gain because of the time value of money (it can earn interest). Moreover, when the principal is repaid, it will be less than the amount borrowed on an inflation-adjusted basis.

But these benefits seem to be of a rather small order, especially when interest and inflation rates are close to zero. Then there are the risks to consider, particularly tax increases.

Consider a hike in rates to 50 per cent after the tax-loss selling in the above example. When the position is sold at $14,000, taxes paid are $1,750 ($7,000/2 x 0.5). Deducting the harvesting gain, net taxes are $1,255 - more than when tax rates remain constant.

Tax rates can go up for several reasons, like when an investor is promoted in their job. Governments may also raise statutory tax rates, especially when public finances are in such dire straits. Indeed, tax rates will be going up in the U.S. in 2013 one way or another due to the "fiscal cliff" of expiring tax cuts.

There might be some investors for whom the practise bestows a worthwhile benefit, such as those who know with certainty that they will be in a lower tax bracket, or donating to charity. But for others, the benefits appear to be questionable, and could even end up losing money for them.

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READERS: Is it a good idea to harvest tax losses? Should it even be allowed?

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