How to harvest tax losses when markets are down in 2022

There's no sugarcoating the stock market's 20% plunge, but there is a small consolation prize: You have one of the best opportunities in years to lower your tax bill. 

That's because the U.S. tax code allows investors to sell poor-performing stocks and use those investment losses to offset capital gains from selling better-performing assets, such as stocks, bonds, a home or business. If your losses exceed your gains, you can even deduct up to $3,000 against your taxable income. Losses beyond $3,000 can be carried forward every year until death (!) to offset gains in future years.

The extent to which the strategy — known as tax-loss harvesting — can lower your tax bill and boost returns isn't insignificant. According to research from Derek Horstmeyer, a finance professor at George Mason University, when the Standard & Poor's 500 Index has yielded a negative return, the average benefit of harvesting losses provided a bump of 3.21 percentage points (for investors facing a 25% capital gains tax rate).  

So if you're sitting on paper losses, what are you waiting for? You might as well use them to your advantage and sell before the year is out. Any capital losses incurred in 2022 can be used against gains from this year and beyond when you file your tax returns in April. But most investors should buy back a similar stock or fund right away to keep their portfolios balanced and stay invested if the market starts to turn around.

The Internal Revenue Service's wash sale rule says the sale of a security won't be considered a capital loss if you buy the same security or one that's "substantially identical" 30 days before or after selling it. You won't get fined if you run afoul of the rules, but you won't be able to get the tax write-off. And don't think if you sell something in your brokerage account you can just buy it right back in a retirement one — the wash sale rule applies across all an investor's accounts.

There's some murkiness around what "substantially identical" means and not much in the way of case law explaining it, either. Are different share classes of Alphabet Inc. substantially identical? How about a mutual fund sold by a different company that tracks the same index? 

Typically, a brokerage firm will flag anything that's disallowed on the 1099 form it sends you in January detailing gains and losses from transactions during the prior year.

You're better off being more conservative and then swapping for what you really want after the 61-day waiting period, especially considering how low trading fees are these days. (It's 61 days because, remember, the 30-day waiting period applies both before and after the sale.)

For some mutual fund investors, the benefit of tax-loss harvesting will be amplified. In December, fund investors may be in for a nasty surprise — not only will most have suffered negative returns, but they may also be receiving a capital gains distribution.

It's because of the way mutual funds are structured; if other investors want to sell their shares, the fund often has to sell appreciated holdings to meet those redemptions. Investors who remain in the fund are then on the hook for any gains the fund makes from selling those shares. If you hold those mutual funds in a taxable account, you could owe tax, even if you reinvest the gains back into the fund.

There were record-level mutual fund capital gains distributions in 2021; 2022 isn't expected to be quite as bad, but it's still something fund investors should be thinking about and planning for, says Jim Miller, a certified financial planner in Chapel Hill, North Carolina. Locking in stock losses now can help to offset those unwelcome distributions.

Remember the difference between short-term and long-term holdings when thinking about what to sell. The IRS considers short-term to be less than a year, so if you sell an asset within that time frame, you'll be taxed on any gains at the same rate as ordinary income, with a top rate of 37%. Long-term gains are taxed at a top rate of 20% (plus a 3.8% tax for higher earners).

If you sell a stock to harvest the loss and plan on buying it back after the waiting period, remember the clock will be reset again before it can be considered a long-term gain when you eventually sell.

Finally, crypto. Those investors can tax-loss harvest just like stock investors. They have an advantage, though — the wash sale rule doesn't apply to digital assets, so they're able to sell and then buy the same coin without waiting. Still, some tax experts warn crypto investors could get burned by the IRS's economic substance doctrine. That rule basically says that you can't do something just for a tax benefit, meaning you'd have to expose yourself to some sort of market risk before buying the same coin, according to Matt Metras, an accountant in Rochester, New York, who represents taxpayers before the IRS. But whether that's 10 minutes or 10 days is anyone's guess. As with stocks, it's better to err on the side of caution.

It's been a rocky year in the markets, but smart moves now can make taxes less painful in April.