Here's One Big Silver Lining of Down Markets

It's not all doom and gloom for investors with a long time horizon.

During hard economic times, it can be difficult to focus on the upside. Long-term investors, however, should tap their inner optimist thanks to one big opportunity: tax-loss harvesting. What is tax-loss harvesting and why is now a great time for it? Read on to learn more.

What is tax-loss harvesting?

At its core, tax-loss harvesting is a strategy that turns losing stocks into taxable losses. The strategy is simple: sell stocks that are underperforming and recognize a loss on your taxes. These taxable losses can then offset other portfolio gains, potentially eliminating their tax effect completely.

It works like this: Imagine you have XYZ stock which is trading at a loss of $1,000 in a taxable brokerage account. You have capital gains of $3,000 on the year. By selling the XYZ stock, you recognize a loss of $1,000, which reduces your capital gains on the year to $2,000. Simply by selling a losing stock, you have reduced your taxable gain by a third.

When it comes to tax-loss harvesting, understand which of your holdings are short-term and which are long-term. Investments are considered to be long-term if held for more than one year and one day, and are taxed at lower rates. When harvesting losses, short-term losses offset short-term gains, and long-term losses offset long-term gains. If you have gains in one category and losses in the other, the results are netted against each other. Any losses then can offset other types of taxable income.

Know this first

While tax-loss harvesting is a valuable tool during down markets, you must understand two concepts before you put it into practice. Wash-sale rules dictate how you can reinvest the proceeds of a sale and loss carryforwards can affect your taxes for years to come.

Under the wash-sale rule, investors who repurchase identical shares within a thirty day period before or after the sale of stock are not allowed to recognize a taxable loss. For those hoping to take advantage of down markets with tax-loss harvesting, a wash sale can ruin your strategy. There are two ways to avoid the wash sale rule. First, don't repurchase the same shares within thirty days of the sale. Second, purchase similar, but not identical, investments. For example, selling the Fidelity Total International Index Fund and purchasing the Vanguard Total World Stock Index Fund, even if their holdings are similar, would not disqualify you from recognizing a loss under the wash-sale rule.

But what if your entire portfolio is down on the year, and you don't have a taxable gain to offset the loss? Luckily, the tax code allows taxpayers to recognize some loss in the given year and carry their losses forward into future years. You can only recognize a capital loss of $3,000 in a given year, and the remainder can be carried forward indefinitely.

Why now is a great time to harvest

You don't have to ask an economist to know that the economy is facing some serious headwinds. The combined forces of surging inflation and economic slowdown lead many to fear stagflation. Late last week, it broke that the U.S. GDP faced economic contraction for the second quarter in a row, definitionally placing us in a recession. So what does that mean for your portfolio?

If you're like many Americans, your investment portfolio isn't in the best shape right now. But things aren't all doom and gloom. It may make sense to employ a tax-loss harvesting strategy, especially if you have recognized gains earlier in the year. Through tax-loss harvesting, you can make the most of down markets this year and for years to come.