Put Cash in Your Wallet with ETF Tax-Loss Harvesting!

Exchange traded funds (ETFs) are wonderful for many reasons. And as year-end approaches, I want to remind you of a key strategy using ETFs — because it can put money in your pocket almost immediately. Today we’ll talk about “tax loss harvesting”

Losing money is never fun, of course, but it happens to all of us sometimes. Wise investors make the best of the situation.

Now you might wonder about this word “harvest” How can you have a “loss” and a “harvest” at the same time?

Answer …

Think like a Farmer

Farming is, in one sense, pretty simple. You plow up your field, plant your seeds, give them water, and wait. In due course, you will have grain, vegetables, or whatever you planted.

However … your rich cornfield won’t yield any cash unless you harvest it. You need machinery, workers, and good timing.

The harvest is important, even if the yield doesn’t cover your costs.

If you had bad weather or pesky insects, your harvest may be worth less money than you spent planting and nurturing it. So do you let it rot? That’s one alternative. A better alternative, in most cases, is to proceed with the harvest. Sell it for whatever you can get.

Investing is similar. Sometimes you might find yourself staring at an open loss with little hope of recovery. But if you think like a farmer, you’ll acknowledge the loss, make the best of it, and move on.

How to Handle a Loss

Suppose, for instance, you bought a stock last year and it didn’t work out. Your $5,000 investment is now, according to last month’s statement, valued at $2,000. Ouch!

Here are your choices:

1. Ignore the loss and hope it gets better.

2. Sell and put your cash in the bank.

3. Apply a tax-loss harvesting strategy.

Sometimes the first option is the correct one. Particular market segments come in and out of favor. Maybe your losing investment just needs more time. Or maybe it will keep getting worse.

Option #2 is distasteful because it “locks in” the loss. Psychologically, this is hard for most people because it means admitting a mistake. Nothing is more frustrating than selling at a loss and then seeing the stock zoom higher the next week.

Tax loss harvesting gives you a third way. You might not recover your full investment, but you can at least minimize the damage … or even give yourself a second chance.

And here’s the most amazing part: The IRS will actually help you do it!

Who knew they could be so helpful?

The U.S. tax code lets you deduct up to $3,000 in capital losses against ordinary income each year. So if you made money on your job but lost money on your investments, you may be able to “harvest” the investment loss and reduce your taxable income. This could save you hundreds of dollars!

ETFs are key to this strategy because they are often highly correlated to each other (and to certain stocks) without being internally “identical” This is how you can avoid the IRS wash-sale rules.

(Of course, I must point out everyone’s situation is unique and I am not your tax advisor. Always consult an expert before you make tax decisions.)

Three Specific Ideas for
Harvesting Taxable Losses

Idea #1: Replace losing
stocks with sector ETFs

Suppose back in 2010 you were bullish on banks. You invested $5,000 in Bank of America (BAC) shares at $15 each. Now the best you can do is around $6. Your investment is worth about $2,000. You don’t want to sell and swallow that $3,000 loss. But it sure would be nice to reduce your tax bill.

Here’s how to have it both ways …

First, sell your BAC shares before year-end so you “realize” the $3,000 loss in 2011. At the same time, buy an ETF covering the U.S. banking sector. Some candidates are SPDR S&P Bank ETF (KBE) and PowerShares KBW Bank Portfolio (KBWB).

Now what happens? If BAC recovers, the rest of the banking sector probably will, too. You get the benefit of a $3,000 tax deduction now while preserving the possibility of gains later.

Idea #2: Replace losing
stocks with inverse ETFs

Suppose you have a losing stock position with little hope of recovery. In fact, you think it’s going to get worse before it gets better.

Using the same example above, you can harvest the BAC loss and then buy an inverse sector ETF like ProShares UltraShort Financials (SKF). Be sure to use a smaller allocation since SKF is 2x leveraged.

Result: You get your tax loss this year. And if BAC and its peers keep falling into the new year as you anticipate, you also have the potential to make a profit in SKF. That gain won’t be taxable until you file your 2012 return.

Idea #3: Switch around
your China ETFs

If, like me, you’re long-term bullish on China you may be holding an ETF such as iShares FTSE/Xinhua China 25 (FXI). And if you bought last spring, you’re now sitting on a loss. However, you may be reluctant to sell your shares because you want to stay involved in China, which is what I’ve recommended to my International ETF Trader members.

Here’s the strategy: Sell FXI and use the proceeds to buy SPDR S&P China (GXC). Because these two ETFs are based on different indexes, you can make a strong case that they’re not “identical” for tax purposes. They are very similar in terms of performance, however.

The switch allows you to benefit from the capital loss this year while keeping the same allocation to Chinese stocks. What a great deal!

Before you try any of these strategies, think about transaction costs. You’ll be generating extra commissions with each buy and sell.

Also be aware that you can’t write off capital losses inside of an IRA or qualified retirement plan. So those losses can’t be harvested.

If you’re holding open losses in any investment, be sure to talk to your accountant or other advisor about tax loss harvesting. Do it this month and you could find extra cash in your pocket in early 2012.

Best wishes,

Ron