Wall Street banks have found a silver lining in this year’s market rout: making money by helping wealthy clients sell some investments at a loss to lighten their tax bills.
This so-called “tax-loss harvesting” strategy has been around nearly as long as the federal tax code — which came into force in the second decade of the 20th century — but has surged in popularity this year as stocks and bond prices have plunged.
JPMorgan Chase last week launched a new “tax-smart” platform focused on tax-loss harvesting, joining financial groups like Morgan Stanley and BlackRock in offering automated products that help investors benefit from the strategy.
“It’s the only gift you have in a down market. There’s economic value in a loss,” said one wealth adviser at a big US bank, who remarked that the majority of client calls in recent weeks have been about tax-loss harvesting.
Tax-loss harvesting is geared towards investors who have been steadily adding to their holdings over a period of years. Recently acquired stocks that have fallen in value are sold at a loss, which can be deducted from any capital gains made in this or future years. The S&P 500 stock index is down 21 per cent in 2022.
“A priority this year is making sure that at least people don’t pay taxes on their portfolios,” said one private banker at a Wall Street firm.
Typically, investors will sell then repurchase a portfolio with a similar risk profile. Under the IRS’s “wash-sale” rule, investors are banned for 30 days from selling a security at a loss and then repurchasing the same investment.
“With 10 years of bull markets, this is an opportunity where clients are able to utilise tax-loss harvesting,” said another private banker.
Tax-loss harvesting is one of several strategies US banks and money managers employ to minimise taxes for well-heeled investors. Some of these clients also hold on to profitable positions and use them as collateral for loans from big banks, thereby generating cash for expenses without reporting taxable income.
“There’s an overall big picture issue about our tax code and the way it treats the wealthy,” said Steve Wamhoff, director of federal tax policy at the Institute on Taxation and Economic Policy, a Washington-based think-tank. “They have this incentive to realise losses as soon as possible. But then they have this incentive to avoid realising gains.”
The strategy has become more mainstream in recent years through the rise of direct indexing providers such as Morgan Stanley-owned Parametric and BlackRock’s Aperio. These enable investors to own a group of stocks that mimic the performance of an index, and customise the portfolio to manage for tax losses.
Investors in the US pay tax at their marginal income tax rate on gains from assets held for up to a year, with lower capital gains tax rates applying to assets held for longer.
In a note to clients in May, the asset manager State Street Global Advisors wrote that this might be “the largest tax-loss harvesting opportunity in decades”.
By the end of August, 99 per cent of mutual funds and exchange traded funds were trading at a loss for the year, according to State Street estimates. Rising interest rates from central banks around the world have also hit bond investments.
“It has created a really, really bountiful harvest of losses for investors this year,” said Matthew Bartolini, managing director at State Street Global Advisors.
In the 2020 tax year, there were $19.3bn of net capital losses that could be used to offset capital gains, up 19 per cent from $16.2bn in 2019, according to the most recently available data from the Internal Revenue Service.
Tax-loss harvesting is not just for US clients — in the 2020-21 UK tax year, more than £2bn of investment losses were offset against capital gains to lower personal tax bills.
David Henry, investment manager at UK wealth firm Quilter Cheviot, said tax-loss harvesting could be “very very powerful” and was currently popular among buy-to-let landlords in the UK sitting on large gains but selling in anticipation of mortgage rate rises pulling down house prices.
They also make greater savings because capital gains tax in the UK is charged at a higher rate for taxable property than all other assets, at 28 per cent and 20 per cent, respectively, for higher and additional-rate taxpayers.
Henry added that the recent days had presented opportunities in the UK government bond market. Investors nursing losses in exchange traded funds can sell them, crystallise the loss and buy back bonds directly; any difference between a bond price and its maturity value can be kept tax-free.