Investors have suffered their longest bear market in years during 2022. Even after a sizable rebound from the worst levels of the year, many stocks remain down sharply from where they were in January. That has experienced investors looking for ways to capitalize on opportunities, and one thing they're looking at is doing some year-end tax planning in the hopes of paying less in income taxes come next April.
In bear markets, many investors have positions with substantial declines in value from where they made their initial investments. A strategy called tax-loss harvesting can be a useful way to get at least some partial payback for those losses.
Yet if you think stocks will rebound further, there's a key tax rule you need to understand. Otherwise, you could lose the tax break you've been hoping to cash in on.
Image source: Getty Images.
Selling for tax losses and the wash-sale rule
Individual taxpayers don't have to pay taxes on gains until they sell their investments. At that point, they realize a capital gain or loss, depending on whether the value of the investment has risen or fallen since purchase. Before then, though, those gains or losses remain unrealized, and you don't have to account for them on your taxes.
That gives investors full control of their tax planning. When you have big gains, you don't have to pay taxes on them until you sell. Hold for the long term, however, and you'll defer your taxes, as well.
The downside, though, is that in order to claim a tax loss, you have to sell. That's fine if you no longer want to own shares, perhaps because you've lost conviction in the company's business prospects. If you still like the company and expect the stock to rebound, though, then the wash-sale rule comes into play by preventing you from simply selling your shares and immediately buying them back.
The wash-sale rule requires you, instead, to have a period of more than 30 days between when you sell the stock and when you buy replacement shares. Do the buyback before the 30-day period elapses, and your tax loss on your initial sale will get disallowed. The loss doesn't disappear, but it's worked back into the tax basis of the replacement shares, locking it up until you sell those shares.
It's hard to work around the wash-sale rule
Wash-sale rules come into play in other situations, as well. If you sell a stock and then buy an option within 30 days to purchase that stock at a later date, it will trigger the rule. Sell the stock in one brokerage account and buy it back in another, and the rule still applies. Buy back a different share class of the same company -- Alphabet Class A voting stock for Alphabet Class C non-voting stock, for example -- and you also have your loss taken away as a substantial identical security.
As a result, you'll typically just have to wait out the 30-day period. Yet that can cause problems if the timing of the tax-loss sale turns out to be bad. If the recovery in the stock happens during the time that you aren't holding the shares, then by the time you can buy back the stock, it could cost you far more than you received from selling it a month previously.
A way to handle wash-sale risks
One strategy that is allowed, however, is to buy shares of similar companies. So for instance, if you think that Alphabet stock will recover when advertising picks back up, you might consider holding shares of social media ad-giant Meta Platforms for the 30-day period. The hope in doing so would be that if Alphabet stock rises, Meta stock would follow suit for the same reasons.
The reason this is allowed, though, is also the reason why it's not a perfect solution. Meta and Alphabet are different businesses that will perform differently. The shares might tend to move similarly, but in any given 30-day period, it's entirely possible that your replacement position will move in the opposite direction from the stock you sold.
With so many investors seeing substantial losses in 2022, however, you can't afford to ignore the opportunity to reap some tax savings by selling off losing positions. As long as you follow the rules, you'll be able to get something out of losing investments other than disappointment.
