It has been a tough year for the bond and stock market with both the aggregate bond market and S&P 500 down. Although no one likes to see investments down for the year, trustees, conservators, and guardians may want to consider using this opportunity to plan for future gains through tax loss harvesting. However, there are pros and cons of using this strategy that need to be considered from a trustee’s perspective.
What is Tax Loss Harvesting?
The IRS allows individuals and trusts to utilize realized losses from the sale of assets to offset income or realized gains. Up to $3,000 in income per year can be offset with net losses. Losses can also be used to offset any short term or long term capital gains realized in the current year. But, even more advantageous, is the ability to carry the losses forward into subsequent tax years to offset any gains realized in the future.
One way to harvest tax losses is to sell an existing asset and then buy it back. However, the IRS has specific rules about how soon one can sell or buy back an asset previously sold for a loss. These rules are called wash sale rules, and if the same asset (or substantially identical asset) is bought or sold within the 30 days before or after the realized loss, the IRS will not allow this loss to be used.
When harvesting losses, most investors will want to avoid having to wait 30 days to buy an asset back, as it is preferable to stay invested. One way to avoid incurring a wash sale is to buy an asset that gives similar equity or fixed income exposure. For example, suppose an investor is invested in the Vanguard Emerging Markets Stock Index Fund ETF (VEA) for foreign emerging market stock exposure. The investment is at a loss position due to market conditions. The investor wants to harvest the loss, but still wants exposure to emerging markets because they believe the investment is poised for a turn around. An investor might consider selling the Vanguard ETF and buying iShares Core MSCI Emerging Markets ETF (IEMG) with the proceeds. He can avoid the wash sale, and not have to wait 30 days, because although both ETFs are invested in emerging market stocks, they use different underlying indexes. The end result is the investor still gets emerging markets stock exposure while harvesting the loss.
Pros for the Trustee
Tax loss harvesting can be especially beneficial for trustees of irrevocable trusts. This is because irrevocable trusts have compressed tax brackets compared to revocable trusts that are taxed at the beneficiary bracket level.
|Taxable Income Between||Single Filer Tax Bracket||Trust Tax Bracket|
|0 to $2,750||10%||10%|
|$2,751 to $9,850||10%||24%|
|$9,851 to $10,275||10%||35%|
|$10,276 to $13,450||12%||35%|
|$13,451 to $41,775||12%||37%|
|$41,776 to $89,075||22%||37%|
|$89,076 to $170,050||24%||37%|
|$170,051 to $215,950||32%||37%|
|$215,951 to $539,900||35%||37%|
|Taxable Income Between||Married Filed Jointly Tax Bracket||Trust Tax Bracket|
|0 to $2,750||10%||10%|
|$2,751 to $9,850||10%||24%|
|$9,851 to $13,450||10%||35%|
|$13,451 to $20,550||10%||37%|
|$20,551 to $83,550||12%||37%|
|$83,551 to $178,150||22%||37%|
|$178,151 to $340,100||24%||37%|
|$340,101 to $431,900||32%||37%|
|$431,901 to $647,850||35%||37%|
Realized gains and losses to an irrevocable trust can result in a potentially large tax hit. This is because gains are normally considered as contributions to principal and not considered part of the income that is to be distributed to a beneficiary. A trustee may try to mitigate this tax impact as much as possible by distributing the gains as income to the beneficiary, but this is dependent on the language of the trust. Some trusts will give the trustee authority to distribute income and/or principal as needed, while other trusts will state that capital gains are included as part of distributable net income for accounting purposes. It’s important to read the trust to know what options you have with distributing realized capital gains.
This is why minimizing capital gains through the strategy of tax loss harvesting can be advantageous. For irrevocable trusts that are subject to the compressed tax bracket, large trusts that do not offset gains can easily be pushed into the max 37% threshold tax bracket (i.e., gains over $13,450).
Potential Cons of Tax Loss Harvesting for the Fiduciary
When doing tax loss harvesting, one area trustees should understand is how it can potentially impact trust accounting. Some advisors, particular robo advisors, offer tax loss harvesting as part of their suite of services. The trustees may have no control over these automated systems which will sell and buy according to the robo’s parameters.
Depending on the number of investments in the portfolio, this can create a large number of transactions. A high number of transactions is especially disadvantageous for trusts due to costs related to trust accounting. This means that care must be taken when attempting to use tax loss harvesting within a trust.
Another way that tax loss harvesting can turn into an issue is when an account is supervised by the courts (e.g. court supervised trusts or conservatorships). For these situations, a court appointed PVP (probate volunteer panel) attorney may be assigned as an objective third party. Frequent tax loss harvesting transactions might be questioned by the PVP as churning due to multiple transactions occurring in a short time frame.
PVPs also review court accountings from the perspective of carry value, not cost basis. Carry value oftentimes represents the value of the assets at the time the successor trustee was initially appointed. The result is that PVPs see the impact of harvested loss transactions from the perspective of the trust accounting’s time frame and not from the time frame of when the asset was initially purchased (i.e. cost basis). The amount of losses can draw attention to the trustee and require the trustee to take additional effort and expense in explaining the reason for these losses.
Tax loss harvesting is an important tool that can be used to minimize the tax impact within accounts. However, for professional fiduciaries, it should be done in coordination with an advisor who is familiar with the unique aspects of trust investing. If not, the losses harvested can create negative perceptions of the trustee’s actions and/or additional accounting costs and expenses.
Prudent Investors is an SEC-registered investment advisor providing portfolio management and financial planning services for professional fiduciaries, trustees, guardians, and conservators. We specialize in asset management and the unique needs of trustee investing and provide expertise in areas like tax loss harvesting. If you have additional questions related to tax loss harvesting or are interested in partnering with a trusted advisor, connect with our team today.
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