Most stock investors are eager for a fresh start in a new year. However, as ugly as trading accounts are looking—with the S&P 500 now down 11.5 percent year-to-date—there is at least one silver lining to the weak market: investors can take advantage of year-end tax loss harvesting.
Here’s a look at what tax loss harvesting is, key mistakes to avoid, and ways to trade tax loss selling trends in the market.
What Is Tax Loss Selling?
Long-term investors sitting on big gains on stocks such as Amazon ($AMZN) may finally have an opportunity to cash in on some of those gains in 2018 and avoid a steep tax bill. When it comes to capital gains, U.S. investors need only pay taxes on net gains in a given year, not gains on individual stocks. In other words, a long-term Amazon investor sitting on $10,000 in profits on that single position can sell those Amazon shares and completely avoid paying taxes on the profits, as long as that trader also sells several smaller positions with net losses that add up to $10,000.
Additionally, traders who have net capital losses in a given year can offset up to $3,000 of their regular income in the current year and carry over the remaining balance into future tax years.
There are two common mistakes that traders need to make sure to avoid when tax loss harvesting. First, make sure to understand the difference between long-term and short-term capital gains and the current tax brackets for each.
For example, traders with less than $38,600 in 2018 income are exempt from capital gains taxes on any stocks they have held for more than a year. In the Amazon example above, that long-term investor wouldn’t need to offset that $10,000 in profit if he or she earned less than $38,600 in income this year.
However, the major mistake investors make in attempting tax loss sales is to overlook the wash rule. It may seem like a good idea to simply sell a stock on December 31 to record the losses in tax year 2018, then turn around and buy the stock back on January 2 to essentially maintain the position in your portfolio.
This technique is classified by the IRS as a wash sale, and losses incurred are not counted, meaning they cannot be used to offset capital gains. If an investor is selling stocks as part of a tax loss harvesting strategy, he or she must wait at least 30 days to buy back that same stock to avoid the sale being classified as a wash sale.
Stock Loss Trading Strategies
Some of the worst-performing stocks of the year are often prime candidates for stock loss selling, meaning these stocks often experience heavy selling volume in the last two weeks of the year. That selling volume typically eases on the first day of the new year, and some stocks may experience buying volume once January 30 rolls around and tax loss harvesters are allowed to buy back the stock and avoid a wash sale.
This year, the three worst-performing stocks in the S&P 500 are Delphi ($APTV), Mohawk Industries ($MHK), and General Electric ($GE).
Traders with no positions in these stocks and other market laggards may try to ride the wave of late-December selling pressure and also be on the lookout for potential late-January buying.
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Disclosure: the author holds no position in the stocks mentioned.
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