We’ve finally entered a period of time with big drawdown and volatility in the market. While it’s not great that some of your long-term investment temporarily lost value, it’s a good time to consider Tax Loss Harvesting.
As this strategy is related to US income tax, you guessed correctly that it’s not straightforward to implement Tax Loss Harvesting for US expats and expats in the US. This is why I want to address this topic specifically for my readers living internationally.
We’ll first look at the basics of Tax Loss Harvesting. Then we will discuss what different categories of the expat population need to keep in mind when considering Tax Loss Harvesting.
Basics of Tax Loss Harvesting
What is Tax Loss Harvesting
Tax loss harvesting is a strategy to lower taxable capital gains (plus taxable earned income up to $3,000 each year) through selling securities at a loss.
Tax loss harvesting may take two forms:
- Sell and buy back the same securities after 30 days to avoid wash sale rule. Assuming the market did not increase within the days you are out of the market, you are able to claim a capital loss on the tax return while owning the same or more shares of the same securities. However, if the price of the securities never goes below the level at which you sold, you will return to the market with fewer shares of the same securities.
- Sell and immediately buy similar but not substantially identical securities. After 30 days, sell the replacement securities and return to the original investments. Since you avoided wash sale, you are able to claim a capital loss. Regardless how the market moves between the first and second set of transactions, you will own similar number of shares of the same securities as if you did not make those trades. In order to achieve this, the replacement securities would need to behave similarly as the original holdings in the time period.
When can you Harvest Tax Loss
- As indicated by its name, this strategy only applies to taxable investments. It does not work in tax advantaged accounts such as 401(k), IRA, Roth IRA, Health Savings Account, or 529 plans, since you do not incur capital gains tax liability in those accounts.
- You can only harvest capital loss if there is loss to be harvested. If you have bought those securities at a very low price in the past, the prices may never dip below your purchase price again for you to sell at a loss.
- You also need to have US capital gains tax and income tax liability in general. Otherwise you may not get any tax benefit by selling at a loss.
Why is Tax Loss Harvesting beneficial?
- If you already have substantial capital gains in one tax year, such as from selling investment properties (for US tax resident only) or other securities when the market was high, the artificial capital loss may reduce your current year capital gains tax liability.
- If there are more loss than gains in one tax year, up to $3,000 is deductible against earned income.
- Any loss not used in current year will carryover to next year’s tax return as loss available to reduce capital gains or earned income up to $3,000.
- By selling at a loss and buying back at a lower price point, you increase your potential capital gains to a later date, which may be taxed at a more favorable capital gains tax rate. (For example, in years when you have low income and capital gains tax at 0%.) On the other hand, the losses used to offset earned income gives you a tax savings at the marginal tax rate. The difference between the two tax rates on the same income gives you an opportunity to save on taxes in the long-term.
A Simple Example on Tax Loss Harvesting
Let’s say you invested in 100 shares of the Vanguard Total Stock Market Index ETF (VTI) on February 19, 2020. Your purchase price was $172 per share, so your cost basis was $17,200.
Immediately after you bought, the market started tanking. After just three weeks, now a share of VTI is around $142. You have lost on paper 100*($172-$142) = $3,000
To get the tax loss, you would:
- Sell all the shares of VTI at $142. You receive back $14,200 in cash after settlement. You lost $3,000 for real.
- Immediately after you sell VTI, you use $14,200 of existing cash to buy iShares Core S&P Total US Stock Market ETF (ITOT), which has 98% overlap with VTI. You are able to buy at $63.11 per share, which gives you 225 shares.
- After another month, the market had gone down more and rebounded. You sell the shares of ITOT again at $63.11 per share and buy VTI again at $142. Once again you have 100 shares of VTI.
- Since 30 days have elapsed between Step 2 and 3, you are able to report the $3,000 loss from Step 1 as short-term capital loss. If you don’t make any other sale again this year, the $3,000 will be deductible against your earned income to reduce your taxable income by $3,000. The end result is that you reduced your current year taxes, but still own 100 shares of VTI at the lower cost of $142 instead of $172 per share. At some point in the future, hopefully the price of VTI will go above $172 before you sell again, so you do not incur a real loss afterall.
Tax Loss Harvesting for US expats and expats in the US
US citizens or Green Card holder living outside of the US
US expats living overseas still pay US income tax on worldwide income. Therefore, it’s conceivable that you may get some tax benefit by implementing the Tax Loss Harvesting strategy. However, there are some instances you may get less than you expected:
- You have low earned income or use Foreign Earned Income Exclusion. If you don’t otherwise have capital gains, the capital loss in current year will simply get carryover for future years. If you don’t expect to have taxable income above standard or itemized deduction for a long time, you won’t get to use your carryover loss to reduce tax liability for a long time.
- You are also tax resident in another country where tax on investment income is applied differently. In the US, with a capital loss you do not pay taxes. However, in another country, the sales proceeds may be taxable without considering cost basis, or the cost basis is calculated differently. You need to understand tax implications in that jurisdiction before implementing a US tax strategy.
Expats living in the US taxed as resident alien
For as long as you are a US tax resident, you can reap the same US tax benefit using Tax Loss Harvesting. However, if you do not intend to become a US citizen or Green Card holder, you need to consider how the tax loss may be treated in future years when you become nonresident alien.
- If you have large carryover losses, are you able to use up all of it before you leave the US? If not, the unused loss amount is forever lost.
- If you will become nonresident alien one day, you may be subject to lower capital gains tax rate due to treaty, or even zero capital gains tax without treaty. Therefore carryover tax loss may not be useful for reducing future capital gains.
- However, if you are able to use up all the tax loss while in the US and successfully lower your cost basis with Tax Loss Harvesting, you may be able to avoid capital gains tax on larger gain when you become nonresident alien.
Expats living in the US taxed as nonresident alien
(If you are new to investing, you may want to read this post first.)
- Capital gains for most nonresident alien living in the US are taxed at flat 30%. Therefore Tax Loss Harvesting may only be helpful if there is existing gain from selling other securities or taxable dividends in the same category in the same tax year
- Unlike for US tax residents, for nonresident alien, the capital gains / losses from effectively connected income and from real estate sale are treated separately from the gains and loss from trading securities. If you don’t already have taxable income that is NOT effectively connected to a trade or business in the US, the loss is not allowed and therefore does not reduce your other taxable income.
- You may also want to check tax treaty to make sure how your trading in the US impact your taxes in the home country.