Tax-Loss Harvesting: $35K Capital Gains Offset for High-Net-Worth Client

Tax-Loss Harvesting: $35K Capital Gains Offset for High-Net-Worth Client

Executive Summary

Summit Capital, a leading Registered Investment Advisor (RIA), faced a challenge in minimizing the capital gains tax liability for a high-net-worth client after a significant portfolio rebalancing. To address this, David Park, a Senior Wealth Advisor at Summit Capital, implemented a proactive tax-loss harvesting strategy within the client's taxable investment account. By strategically identifying and selling underperforming assets and reinvesting in similar securities, Summit Capital successfully offset $35,000 in capital gains, resulting in a 1.2% improvement in the client's after-tax investment performance.

The Challenge

John Miller, a high-net-worth client of Summit Capital, had accumulated a substantial portfolio over the past decade. Due to significant market appreciation, particularly in the technology sector, his portfolio had become overweight in growth stocks and required rebalancing to align with his long-term financial goals and risk tolerance. This rebalancing necessitated the sale of appreciated assets, triggering a potential capital gains tax liability of approximately $80,000.

Specifically, John held $200,000 worth of shares in a technology company that had appreciated significantly, resulting in a capital gain of $120,000 if sold. He also held $100,000 in a mutual fund focusing on emerging markets, which had experienced modest growth but was identified as a suitable candidate for diversification.

Without active tax management, John faced a substantial tax burden. Assuming a combined federal and state capital gains tax rate of 20% (federal 15% + state 5%), his tax liability would have reached $16,000 solely on the $80,000 gain from rebalancing, eroding a significant portion of his investment gains and hindering the overall portfolio performance. This situation underscored the critical need for a tax-efficient investment strategy. The client expressed concern about the potential tax impact on his investment returns, emphasizing the importance of minimizing tax liabilities while maintaining a diversified and well-balanced portfolio.

The Approach

David Park adopted a comprehensive tax-loss harvesting strategy to mitigate John's capital gains tax burden. This involved a systematic review of John's portfolio to identify assets that had declined in value. The strategic decision framework involved the following steps:

1. Portfolio Assessment: A thorough review of John's taxable investment account was conducted, focusing on identifying assets trading below their original purchase price (basis).

2. Loss Identification: Several underperforming assets were identified, including a technology ETF that had experienced a recent downturn due to market volatility, and a small-cap fund that had underperformed its benchmark. The total unrealized losses identified amounted to approximately $35,000.

3. Tax-Loss Harvesting Execution: David implemented a series of strategic trades to realize the identified losses. This involved selling the underperforming assets, triggering the tax-deductible capital losses.

4. Wash-Sale Rule Avoidance: To avoid triggering the wash-sale rule, which disallows the deduction of a loss if the same or substantially identical security is repurchased within 30 days before or after the sale, David carefully selected replacement securities. For example, instead of repurchasing the exact same technology ETF, he reinvested the proceeds into a similar, but distinct, technology ETF with a slightly different weighting of holdings. He also diversified across several similar funds.

5. Reinvestment Strategy: The proceeds from the sale of the loss-generating assets were immediately reinvested into similar, but not identical, securities to maintain John's desired asset allocation and market exposure. This ensured that John remained invested in the market and continued to participate in potential future gains. The new investments were carefully selected to align with John's investment objectives and risk tolerance.

6. Ongoing Monitoring: David established a system for ongoing monitoring of the portfolio to identify future opportunities for tax-loss harvesting throughout the year. This proactive approach allowed him to continuously optimize the portfolio for tax efficiency.

Technical Implementation

Summit Capital leveraged Black Diamond, a sophisticated portfolio management software, to automate and streamline the tax-loss harvesting process. Black Diamond's built-in tax-loss harvesting capabilities enabled David to:

• Identify Loss Harvesting Opportunities: Black Diamond automatically scanned the portfolio for unrealized losses, highlighting potential tax-loss harvesting candidates based on predefined parameters, such as a minimum loss threshold of $1,000 and a wash-sale avoidance window of 31 days. The software calculates the basis of each security and tracks realized and unrealized gains and losses.

• Model Potential Trades: The software allowed David to model the potential tax impact of various trade scenarios, enabling him to optimize the tax-loss harvesting strategy for maximum benefit. He could input hypothetical sell orders and see the estimated impact on the client's capital gains tax liability.

• Execute Trades Seamlessly: Black Diamond integrated directly with Summit Capital's brokerage platform, enabling David to execute trades efficiently and accurately. The trades were automatically recorded and tracked for tax reporting purposes.

• Wash-Sale Rule Monitoring: The software automatically monitored for potential wash-sale violations, flagging any trades that could trigger the rule. This helped David avoid inadvertent violations and ensure the integrity of the tax-loss harvesting strategy. The system tracks all purchases and sales within the client's account and compares them against each other to identify potential wash sale violations, considering the 30-day window.

• Tax Reporting: Black Diamond generated comprehensive tax reports, including realized gain/loss reports and wash-sale reports, simplifying the tax preparation process for John.

Specific Calculations and Methods:

• Capital Gains Offset: Realized losses were used to offset the $80,000 capital gain from the portfolio rebalancing. The initial $35,000 in losses reduced the taxable gain to $45,000.

• Wash Sale Monitoring: The system monitored all buy and sell transactions within a 30 day window. For example, the system blocked reinvestment in ticker symbol "XYZ" within 30 days.

• Reinvestment Strategy: For the reinvestment, David chose a different technology ETF that tracked a similar index but had a distinct weighting of holdings. For example, instead of IVV he chose ITOT to avoid wash sale violation. This maintained John's exposure to the technology sector while avoiding the wash-sale rule.

Results & ROI

The implementation of the tax-loss harvesting strategy yielded significant financial benefits for John:

• Capital Gains Offset: $35,000 in capital gains were successfully offset, reducing John's taxable capital gains from $80,000 to $45,000.

• Tax Savings: Assuming a combined federal and state capital gains tax rate of 20%, the $35,000 capital gains offset resulted in a direct tax savings of $7,000 ($35,000 x 20%).

• After-Tax Investment Performance Improvement: The $7,000 tax savings, relative to John's overall portfolio size of $600,000, translated into a 1.2% improvement in after-tax investment performance.

• Portfolio Diversification: The reinvestment strategy helped maintain John's desired asset allocation and market exposure, ensuring that he continued to participate in potential future gains.

• Reduced Tax Complexity: Black Diamond's comprehensive tax reporting capabilities simplified the tax preparation process for John, reducing the burden of manually tracking and reporting capital gains and losses.

Before & After Comparison:

This analysis shows a tangible improvement in John's financial situation due to the proactive tax-loss harvesting strategy.

Key Takeaways

For other advisors considering implementing tax-loss harvesting strategies, the following takeaways are crucial:

1. Proactive Approach: Tax-loss harvesting should be a proactive and ongoing process, not just a year-end exercise. Continuous monitoring of the portfolio for loss harvesting opportunities can maximize tax benefits.

2. Technology is Key: Utilize portfolio management software with tax-loss harvesting capabilities to automate and streamline the process. Black Diamond, Tamarac, and other platforms can significantly improve efficiency and accuracy.

3. Wash-Sale Rule Awareness: Thoroughly understand and actively avoid the wash-sale rule. Ensure that replacement securities are not "substantially identical" to the sold assets and carefully monitor all trades within the 30-day window.

4. Client Communication: Clearly communicate the benefits of tax-loss harvesting to clients and explain the rationale behind the trades. Transparency and education can build trust and enhance client satisfaction.

5. Integration with Financial Planning: Tax-loss harvesting should be integrated with the client's overall financial plan and investment objectives. The strategy should be tailored to the client's specific circumstances and risk tolerance.

About Golden Door Asset

Golden Door Asset builds AI-powered intelligence tools for RIAs. Our platform helps advisors automate complex financial tasks, unlock personalized insights, and deliver superior client outcomes. Visit our tools to see how we can help your practice.