Tax Loss Harvesting

Taxes are a thorny topic to cover, even for a finance blog.

A 1% saving on taxes equals 1% more in (net) returns, and we all know how hard is to increase returns even by just 1%. But taxes serve a social purpose: they are used to run schools and hospitals and to fix roads. Cutting your tax bill means contributing less to that stuff.

Every country has its own rules around taxes. Some tax more and some tax less. Some spend taxes in a sensible way and others do not.

Your view on taxes is most likely different from mine. You (according to Google) live in another country than I do. Why do I put myself in this clusterf(*k? I do not know…

I recently joined the “FinanceDrip community” and I was amazed by the relative preponderance of discussions around the best possible way of taking advantage of tax losses. FinanceDrip is mainly an Italian community, even if technically the platform has also an English version. I will try to keep this first part as country-agnostic as possible and then add (maybe?) some considerations related to the Italian regulatory environment in the specific.

The Basics

If you are running a proper investment strategy, you should not have to (ever?) deal with losses. Think about it. During the accumulation phase, you buy stuff. And you buy stuff that you expect to go up in price.

If your portfolio has multiple assets and you rebalance them regularly, you sell the asset that went up to buy the one that went down. The only occasion when you incur a loss is when all your assets went down in price at the same time and went all down more than your historical purchase price. If you are in the accumulation phase, this event is even less probable because it means that the portfolio addition is not enough to rebalance the portfolio, i.e. the worst-performing asset did terribly compared to the others.

During the decumulation phase, your portfolio should have compounded so much that whatever you are selling, you are realising a gain.

Tax Losses

Using these lenses, the only reason why you would generate a tax loss (outside a deliberate tax loss harvesting strategy, which we will address later) is…because you fuck’d up. You realised your risk appetite was not that high. You lost faith in that asset class. You YOLO’d on a stock.

At least, you are ready to turn the page. Great!

And yet…you want to remedy a bad choice with…another bad choice?!?

Instead of aligning (finally?) their portfolio to their target asset allocation, people who have some tax losses to harvest turn to short-term bonds that trade below par. That is the surest way to generate a tax-free profit, no doubt about it. But I do not think is worth it.

4-year Euro Govies yields 3.43%: even if you get that net of taxes, a simple 60/40 should generate an average return of 7.4% gross and 5.5% net of a 26% tax (the rate Italian investors pay). It is not guaranteed that you would get that 5.5% but you have a 4-year horizon to get there. If the 60/40 would only start to align its performance to its historical average AFTER those four years, meaning you would lose all your tax benefits, you would still have other losses to compensate for the portfolio’s future gains. This means that in those 4 years, your portfolio would have gained 5.5% instead of 3.43%.

This is probably not the best way to explain what I have in my mind but if you sit down a bit I bet you would get there. The worst scenario for the 60/40, the one where you pay all the taxes, it is still better than the best scenario of using the bonds to harvest the tax loss.

If you forget tax optimisation, and I mean done this way, you can start your new investment life today instead of in 3 or 4 years (however long it would take you to harvest all your losses): it is a huge behavioural benefit!

After a disastrous 2022, there are plenty of bonds that offer enticing returns, especially compared to the recent past, as a soft pillow to lay on. It feels like a layup, a safe corner where you can rest and forget a tumultuous past. I get it. But do not fall for it, please.

Finding ways to reduce your tax bill is hard to impossible, so I understand why many would feel stupid risking to leave this opportunity on the table.

Tax Loss Harvesting

“Tax-loss harvesting is the timely selling of securities at a loss to offset the amount of capital gains tax owed from selling profitable assets.” – Investopedia

I heard for the first time the concept of Tax Loss Harvesting when Patrick O’Shaughnessy launched Canvas, his Direct Indexing platform for financial advisors. In short, Canvas allows FAs to build portfolios out of single stocks instead of ETFs linked to indexes; the benefit is that they can tailor portfolios to their client needs up to the single names, excluding their employer stock (to which they are already exposed through their salary) or other companies that conflict with their values (a tailor-made ESG).

Owning single names means that every year there will be stocks that generated a loss, even in years when the whole index posted a gain. This fact, combined with the notion that you do not need all 500 stocks to replicate the performance of the S&P500, allows Canvans to perform the tax loss harvesting magic. In practice, the software sells a name in the, for example, consumer staple sector that went down and buys another one, in the same sector, that was not included in the portfolio. This way, the portfolio maintains the same statistical risk/return profile but now the investor has a tax loss to offset capital gains made somewhere else. If the investor owned an ETF linked to the S&P500, they would not have this option.

Cool, I thought. And then I moved on to something else since this is a service I would never access anyway unless I win a lottery I do not buy tickets for. It is also a solution that is completely useless in the corporate world, so it is not that having a deeper understanding would have helped me there.

But I left this topic thinking that the tax saving is something permanent. In hindsight, it is just a way to delay a payment that would eventually materialise.

FIREing in Italy

In Italy, the capital gain tax is set at 26%. If you are saving for your retirement, be it RE or not, there is no way to go around it. Having to pay a quarter of your gains to the tax man means that you need a pot way higher than in other places to cover your projected expenses; in other words, compounding works less efficiently. Funny enough, if you worked outside Italy and decide to become a tax resident during your retirement, they offer you a generous tax discount. Somehow, this does not trigger those that are against immigration ¯\_(ツ)_/¯

When a reader asked me if there was a way to lower the cap-gain tax bill, I thought that Direct Indexing, and the associated tax loss harvesting trick, would be the solution. That’s when I realised, Excel at hand, that TLH is just a postponement of the bill.

When you sell the stock that has a paper loss, you are also resetting that position to a lower purchasing price. You are simply loading up your tax bill inside that asset.

Sure, delaying the tax bill is better than paying upfront because you can still have those funds to compound until you are forced to sell them. And this advantage is higher the higher the tax rate. But this effect is an order of magnitude lower than having the bill totally cancelled. And then, you have to pay taxes on those gains 🙂

Still, Direct Indexing might help in the following cases:

• I am not sure what’s the probability of owing stocks that lost money over a long horizon, say 30 years, but I guess is..not that low? According to SamRo, only 22% of the stocks in the S&P500 outperformed the index itself from 2000 to 2020. This means that when you start to withdraw from your portfolio in retirement, you can delay a bit the tax bill. And this is a non-negligible help when facing a sequence of return risk.
• If your portfolio is a mix of stocks and bonds, at each rebalancing event you might have to pay a bit of CG tax (remember, you sell the asset that performed the best). By harvesting, you can delay that tax bill.
• If Italy wasn’t already like a mad-house in terms of tax rules, they decided that ETF losses cannot be compensated with ETF gains but only with gains generated by individual stocks, bonds and certificates. This means you can use losses in bond and commodity ETFs to “reset higher” some individual stock positions.

Before you get excited, I have to mention a couple of issues that will make this whole part about Direct Indexing just a nice piece of theoretical knowledge.

According to the research mentioned in this article, you need a lot of names to be sure your performance will track the index: not just 30/50 as previously thought but 250/300. That’s quite the stuff to manage. And to get the full benefit, you have to start building the single stock portfolio early; the longer you wait, the higher the chance you will have to unwind positions and pay CG taxes or ‘risk’ to accumulate only small unrealised gains and losses.

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