Warren Buffett didn't become the globe's best investor by thinking short term, and he didn't become one of the industry's most trusted soothsayers by holding his tongue. Buffett's investment success and folksy easy-to-understand advice make him one of the best in the industry to learn from, which is why investors may want to pay attention to what the Oracle from Omaha has to say about tax-loss selling.
What is it?
No one likes to pay taxes, so it's not shocking to learn that investors have widely embraced the concept of tax-loss selling. This tax-reduction strategy allows investors to sell losing investments and apply those losses against gains they've taken during the year.
For example, an investor who has sold investments producing a $1,000 gain could sell an investment with losses of $1,000 to offset that gain, and avoid being taxed on it. Short-term losses can be applied against short-term gains, and long-term losses can be applied against long-term gains. Once that calculation is done, investors can then apply any remaining short- or long-term loss against any short- or long-term gain.
If any losses are still left over, then the IRS allows investors to use up to $3,000 of them to reduce taxable income, too. Any additional losses can be carried forward to future years.
It sounds like a great strategy. And for some it is. But there is a catch.
In order for the loss to be used to offset gains, it must be sold by the end of the tax year. Additionally, investors can't repurchase the same stock, or a derivative of it, such as an option, for 30 days.
Buffett has offered up an opinion on taxes that should make investors pause before clicking the sell button on a losing investment. In Buffett's letter to investors in 1965, he wrote:
What is one really trying to do in the investment world? Not pay the least taxes, although that may be a factor to be considered in achieving the end. Means and end should not be confused, however, and the end is to come away with the largest after-tax rate of compound.
Buffett went on to warn investors of the risk of acting blindly based on their distaste for paying taxes.
Buffett's statement is a valuable reminder to investors because it shifts the focus back from selling a stock to offset a gain to answering the question, "Has anything changed at the company that would make me want to sell?"
That's a far more important question to be asking of your losing investments. The answer to that question should significantly outweigh the decision to take a taxable loss in order to reduce your tax bill.
Mr. Market's inevitable pops and drops mean that even the best businesses can punish investors some of the time. However, selling great companies in order to reduce tax payments could prove to be folly. That's because investors have a tendency to avoid repurchasing stocks that they've sold at losses for fear of repeating their mistake. As a result, selling a loss simply to offset a gain could result in missing years of spectacular growth.
A better solution, at least in Buffett's eyes, is to focus on the long haul. If something has fundamentally changed to the reason behind investing in a company, by all means sell and take the loss. But if nothing has changed but a stock's share price, it may be best to just sit on your hands and not push the sell button.
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