Over many years of educating investors about direct indexing, we have noticed a common misunderstanding—conflating the economic value of harvested losses with the investment return on the performance statement. Here’s why those values are not the same thing.
What does it mean to have economic value?
The value of investment return is delivered and can be measured every second of every trading day. By contrast, the value of harvested tax losses is not immediate.
For example, a loss harvested in the early April market sell-off cannot be used until tax returns for 2025 are filed—at least eight months later. And the investor’s circumstances will determine whether the loss can be deployed. If not, it will be carried forward for another 12 months, when circumstances will again dictate usage. And so on, year by year.
In this light, capital losses can be viewed as an asset on the balance sheet of the investor, in the same way that accounts receivable are an asset on the balance sheet of a corporation. In other words, a capital loss is an expectation of monetary value to be received in the not too distant future.
Following this line of thought, remember that the dollar amount of accounts receivable is booked at face value for accounting purposes, but the actual value received may be less than expected or may never even materialize. Likewise with harvested losses, the actual value depends on factors such as the investor’s federal and state tax bracket that year and the availability of capital gains of the same character as the capital losses realized.
Understanding how tax law may affect the economic value of harvested losses can help advisors not only craft and individualize their tax planning services better, but also provide greater clarity in their communication with investors.
How does tax law affect the economic value of losses?
Limitation on use of carryforward losses. One selling point of tax managed investing is that the harvested losses can be carried forward in perpetuity. While that is technically true, there is a catch: The Internal Revenue Service (IRS) does not allow the “opportunistic” use of losses carried over from previous years.
This means that losses must be used to offset existing gains for the year or reduce income by $3000—not deferred until taxpayers can expect to extract the highest offsetting value from them. Only the unused overage is allowed to be carried forward. Since the vast majority of harvested losses generated by direct indexing are short-term in character, then the losses will be deployed sub-optimally if investors are not in their historically highest tax bracket, or if the character of the gains realized that year is long-term only.
Wash sale violation. A harvested loss that violates the wash sale rule1 precludes the investor from realizing the loss at that time. Instead, the loss must be used to adjust the cost basis of the “replacement security” higher. When the replacement security is sold, this adjustment produces either a greater loss or a smaller gain than it would have prior to the adjustment—essentially deferring the original harvested loss. This may result in the loss being recognized in a year when the deduction is worth less because of lower income or no gains to offset.
If the loss is harvested in a taxable account, and the replacement security is purchased in a tax-deferred or tax-exempt account—for example, a traditional or Roth IRA—this results in the disallowed loss being permanently barred because the subsequent loss would be realized in a nontaxable account.
Carryforwards indefinite, not infinite. Unused losses can be carried forward indefinitely—up to the investor’s death. A surviving spouse can use the deceased investor’s capital loss carryforwards to offset realized gains on their final joint tax return for the year of death only. Any losses not used to offset gains in that year become null and void. However, the surviving spouse inherits assets at a stepped-up cost basis, so they would not have tax to pay tax on the gains of those assets. Any future realized capital gains would have to be offset by future realized capital losses.
The bottom line
Direct indexing may potentially produce notable long-term value for investors by providing core market-like investment returns with greater overall portfolio tax efficiency. But assessing the value of losses is not as simple as looking at a performance statement. The true economic value is often variable and dependent on the factors discussed above. Viewing capital losses as a tax planning tool—with utility for multiple applications to improve investment outcomes—allows advisors to have deeper, more meaningful conversations with their clients.
1 In a wash sale, the same security sold for a loss is purchased 30 days before or after the sale. If a transaction violates the rule against wash sales, the IRS can disallow the loss deduction and add the loss to the cost basis of the repurchased security, which can effectively defer the benefit of the loss.
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