Ep. 112 | Capital Loss Harvesting Explained
Download MP3Everybody, welcome back to the teaching tax flow podcast, episode 112. We are gonna dive deep into advanced capital loss harvesting strategies. And before we do that with our guest on this episode today, let's take a brief moment and thank our episode sponsor.
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Chris Picciurro:This might be the first time in over a 100 episodes that I'm introducing, everyone to the podcast first, but Chris Pacuro here teaching tax flow. My co host John Chapulski is with me today, and we have some amazing special guests. We are approaching year end. And although we truly believe in teaching tax flow that tax planning and strategy is a year round activity, your tax return is a verb and not a noun, the the most time compression or rather the the most work compression when it comes to implementation of a tax strategy does occur in the 4th in the 4th quarter. It is weekly that that people within our teaching tax flow community, or our private CPA practice ask questions about what can they do when they have a capital gain.
Chris Picciurro:Real story, just this week, I had someone in my community reach out. He sold his, his home for a large, large capital gain, a capital gain that exceeds the section 121 exclusion, and we're always looking for different strategies to mitigate that legally and ethically, reduce the tax you pay in your lifetime. And one of the main things to understand about capital gains is that the easiest thing you could do to mitigate a capital gain is to have capital losses. So this episode is dedicated to capital lost harvesting. I have 2 amazing special guests.
Chris Picciurro:And before we jump into exactly what a capital loss is and some of the nuances of the difference between capital gains and losses and their proprietary strategy, I wanna introduce our amazing guests, Alex Caswell, Colby Davis from RHS Financial. Gentlemen, how are you doing today?
Alex Caswell:Doing pretty good, Chris. Thanks for having us on.
Colby Davis:Yeah. Great, Chris. Thanks thanks for having
Chris Picciurro:us. Well, my pleasure. My pleasure. Can we'll start with Alex. Alex, can you give us a little and and I'm gonna we're gonna be a little, train we're always transparent here, but, Alex and I work on many, many mutual clients.
Chris Picciurro:So we know each other, from the more from the private CPA practice end of things. It's always an honor when I get to take take resources that we utilize and work with in our private CPA practice, financial advisors that we collaborate with on on mutual clients, and and bring that knowledge to the masses, to the teaching tax law community. So, yeah, Alex, can we start with you? And just give us a little personal background and how you got into doing what you're
Alex Caswell:doing. Yeah. Absolutely, Chris. And, yeah, great to be on the podcast with you and, always excited to work on the clients that I've sent to you because they're always looking for new and savvy ways to reduce their tax bill, which is something that we talk a lot about at RHS Financial. But, yeah, a little bit about myself.
Alex Caswell:So I'm a wealth planner at RHS Financial. I've been at the firm for about a stick going on 7 years now and had a relatively long career. I started at Charles Schwab, worked as a trading specialist, helped a lot of individuals, kind of with creative trading strategies, worked as an advisor for Charles Schwab, then worked as an advisor for Fidelity. I even had a little stint trying to start my own Fintech. I'm here in the Bay Area.
Alex Caswell:That's everybody's dream here. That, failed spectacularly, but it led me to a really amazing career here at RHS Financial. You know, a little bit about my personal background. I'm actually, a, a Latvian born, individual. So I came to America when I was 11 years old, raised by a single mom.
Alex Caswell:She didn't know anything about finances. So, seeing how she was struggling with her own finances really let me down this rabbit hole of understanding how it works. It just really created this passion to me, for personal financial planning. So, yeah, at RHS Financial, my primary role is assisting clients with very comprehensive suite of wealth management services, everything from, you know, guiding them around their investing, but also doing a lot a lot of tax planning because a lot of people in the Bay Area, really in the country, the type of clients that we work with, are in a very high tax bracket. They're w two income employees, and usually, there's quite a lot of pain points there that we're trying to solve for these clients.
Chris Picciurro:Well, that is awesome. And I didn't know you moved to the states when you're 11 years old. See, I just wanted some
Alex Caswell:Yeah. I have zero accent zero accent. I I lived in Texas for a while, got bullied a lot. So I learned how to speak like a true American. And, Yeah.
Alex Caswell:But I still I speak fluent Russian, and I go back to Latvia, almost every single year to visit my grandmother. She's 91 years old now, and, she's very important to me.
Chris Picciurro:Wow. And do you have a lot of clients that are, Russian Russian speaking?
Alex Caswell:I have I have a few, but we speak Russian to each other almost like as a matter of a joke. You know? Just kind of everyone is so much more used to speaking English. But, yeah, I have a I have a few clients. I'm gonna write I start speaking Russian.
Alex Caswell:They're always super surprised by, the fact that I know how to speak Russian, but they all they all say I sound like they say I sound like an American who learned how to speak Russian.
Chris Picciurro:I guess that's a compliment. I well, I knew you're in the Bay Area for quite a while. I was just I didn't I thought you might have grown up there, and I was gonna ask if you're a Ace or Ace fan or a Giants fan. I know the A's are moving eventually.
Alex Caswell:But Yeah. You know, I've been to a few Giants games and a few Ace games. You know, don't don't have Allegiance either, to be honest, but it's both both fun teams to go watch.
Chris Picciurro:Awesome. Well, thanks for joining us. And one of your colleagues, Colby Davis, is with us as well. Colby, if you're if you're watching on YouTube, you'll know that Colby has an amazing head of hair, beautiful. And, unfortunately, you know, everyone that's part of this podcast knows that I do not.
Chris Picciurro:But if you're listening, trust me. But, Colby, thank you, so much, for for joining us. And, tell me a little bit about yourself and how you've how you came to work with Alex and the rest of the team at our RHS.
Colby Davis:Yeah. That's that's what everyone comes here, to RHS for is the is the full head of hair. And, you know, our, our principal and founder, Ricky Scams, actually had a pretty, epic, heavy metal hair hairdo back in his heyday as well. So it's a little short of these days, but, yeah. So I've been at RHS Financial since 2012.
Colby Davis:By the way, the firm was started in 2009 by our founder, Risley Sams, who had been in the brokerage business for many years. He started the firm, I think, 3 or 4 days after the bottom of the financial crisis in March of 2009, took all of his clients from, Merrill Lynch and went independent. And, you know, we've been, you know, chucking along ever since. I joined him in 2012 as a you know, to help him with, you know, all sorts of tasks, but I have, evolved into the portfolio manager here at RHS Financial. So I'm the one doing the day to day trading, rebalancing of the portfolio, also looking at more, you know, complex analytical issues as they relate to the portfolio and as will relate to our conversation today, how, investment strategy interacts with, tax strategy and how to, position the portfolio for our clients to maximize the tax efficiency, maximize tax loss harvesting as we'll talk about today.
Colby Davis:And so, you know, I, I grew up, grew up here in Seattle, majored in economics and fell in love with finance pretty early. And so actually, you know, my first real job out of school was actually in the solar finance industry, but I knew I wanted to get into, portfolio management and wealth management. And, met, met our founder, Risley, actually, by chance in an elevator and give him a literal elevator pitch why he should hire me. And so that's why and now I've been here ever since. So, and we're, we've been we've been rock stars ever since.
Chris Picciurro:And, Colby, so you're from Washington, and are you do you still reside in Washington state, or did you, relocate also?
Colby Davis:I've been in the Bay Area since 2010. So, yeah, our our farmer's based in San Francisco. I'm in San Francisco. I'm in my home office today.
Chris Picciurro:Absolutely. And I know you guys are both into music, so that's pretty cool. A lot little creativity, going on, which is which is awesome. Well, thanks again for joining us. We're gonna dive into some of some some things with you as far as capital loss harvesting.
Chris Picciurro:But before we jump into that, I just wanna give everyone kind of a take a breath if you're listening. Before we start doing a little bit of heavy lifting, let's take things back to a 30,000 foot view, and let's remember, one of the things we talk about all the time in teaching tax law is that that, income is taxed at different rates. So different types of income is handled differently for tax purposes. Capital gains and losses are handled differently than your ordinary income, which would be or earned income, like our w two wages and and, self employment income or even other types of income like rental income. So with capital gains, capital gains, if they are long term, meaning you've owned the asset for a year longer, there are special tax rates, which in general are about half of the normal federal tax rate, in in capital in in short term capital gains are taxed at whatever your marginal tax rate is.
Chris Picciurro:Well, that's great, but you might have capital losses. And capital losses mean that, you have an asset, and that asset has gone down in value, and you have sold that asset. So before I do so what we have to understand is that we have there we have different types of capital gains and losses. We have unrealized, meaning you might have bought a stock or mutual fund for 1 x amount of dollars, and it has increased or decreased. We're not talking about unrealized capital gains and losses right now.
Chris Picciurro:Those don't show up on your tax return in general. We're talking about rec realized capital gains and losses, meaning you sold the asset and generated either a capital gain or loss. Well, if you have a capital loss, unfortunately, capital losses are limited as far as how much we can deduct each year. And that limitation is $3,000 per year unless you file married separately, and that's $1500 per year. So let's say you sold a stock and had a loss of $5,000 in 2024.
Chris Picciurro:You could deduct $3,000 of that in on your 2024 tax return, assuming you're not filing married separately. The remaining $2,000 doesn't go away. It carries forward. So capital losses, when they're by themselves, aren't a huge tax benefit when they're realized. However, when they're paired with a capital gain, they could be very powerful.
Chris Picciurro:Remember I said you can only deduct up with, in general, $3,000 worth of capital losses? That's if you don't have any capital gains. So if you took my example of $5,000 of capital loss and you had a $10,000 capital gain, you would be able to offset that entire capital gain with the capital loss. And common capital gains are not just stocks and bonds. They could be real estate properties, mutual funds, EFTs, cryptocurrency.
Chris Picciurro:We're seeing we know that there's gonna be a lot more required reporting with the advent of a 1099 DA, which stands for digital asset, in the next couple of years. But I'd say Alex and Alex and Colby, other than what people think of capital gain or loss, they typically think of a stock, a bond, and mutual fund. What other types of assets could trigger a capital loss, but that you've seen in your practice?
Alex Caswell:Let me think about that. I I think, very rare, but sometimes it happens. We've seen real estate trigger capital losses. Rare rare in the Bay Area. Usually usually, it's a capital gain.
Alex Caswell:What else? A lot of times, and usually this is not a not a big one, but I think both Colby and I have seen this, but, Climb may have invested in some, stock 10, 20 years ago, and it got delisted. Right? And now essentially
Chris Picciurro:Free lock.
Alex Caswell:Sits in their brokerage statement. It looks like a bunch of numbers. Those numbers are called a QSIP. And essentially, I believe, Colby, correct me if I'm wrong, but you have to reach out to the brokerage firm to ask them to write that off your statement so you can actually realize the capital loss. And sometimes that's a that's a pain in the butt to do so, people forget about that.
Alex Caswell:Yeah. Well, Colby, anything else you've seen? I mean, you've dealt with all these portfolios, so
Colby Davis:you probably know more. I think I'm actually asking what was the examples of capital gains. Correct. Correct. Outside
Chris Picciurro:of your typical, you know, like, I bought Google.
Colby Davis:It's all it's all both sides, different sides of the same coin. Right? So anything that could be a capital gain could also be a capital loss depending on which way it goes. But yeah. So so, you know, stocks and bonds and mutual funds and ETFs and those sorts of things you'll find in the brokerage are what you'll usually encounter, what we usually encounter in terms of capital gains, but certainly it can be the sale of a property, whether your own property, if it's an, an excess of the exclusion or an investment property, could be the sale of the business.
Colby Davis:Maybe you are a a small business owner and you're you're getting out and that could trigger a large capital gain. So pretty much the sale of any asset. It could even be, these have some special laws, but it's at the sale of, an on a work of art or gold or things like this. So, basically, any asset that you own that you're you're selling, for more than the price you bought of that is potentially a capital gain event.
Chris Picciurro:Absolutely. And I think we you know, we so a couple of things that are popular. Let's just talk about the real estate portion. You know, we know if it's a primary residence in general. You can exclude up under section 121 up to a half $1,000,000 of gain, or 250 if if you're on you know, based on your filing status.
Chris Picciurro:Also with real estate, you have that option to have do a 1031 exchange. There are some positives and negatives with that. But when we talk about other capital gains, like you guys said, especially in in in you're in the Bay Area, but I know you work with clients all over the country. A lot of times people have have, employee stock, employee stock that triggers a capital gain. And a lot of these capital gains where they they have this influx of income, and they might not need that cash.
Chris Picciurro:So they're paying tax on that capital gain. Like Colby said, it could be it could be a collectible. It could be gold. It could be it could be digital. There could be digital assets too.
Chris Picciurro:You just you never know what it could be. And and, unfortunately, you know, I shouldn't say unfortunately, but with real estate, there's a lot of things you could do, like I said, with that 1031 exchange. But let's say you sold your business. Let's say you owned a owned a business and you sold this, your business or your the goodwill of your business, you could have a large capital gain. So when you have that situation and you're thinking yourself, okay, well, I have this capital gain.
Chris Picciurro:I really don't need the cash, so I don't wanna pay tax on the cash. What can I do with this to and and, you know, what are my what strategies can I use? And and the lowest hanging fruit's gonna be capital losses. So can you guys kinda talk a little bit about, you know, in in again, the market could be up and down, but the what capital loss harvesting is? And then after, you know, from a basic level, and then I'm gonna then we're gonna talk about something that you guys have developed at RHS that's that's proprietary, that is on a really exciting advanced capital loss harvesting strategy.
Chris Picciurro:But from a basic level, can you explain capital loss harvesting? Because a lot of times people say, well, my my, you know, my account went down. That that that doesn't necessarily mean it's a recognized capital
Alex Caswell:loss. Yeah. And, I'll actually let Colby explain, capital tax loss processing. He is the brains of our firm without a doubt. But one of the things I also wanted to mention just really quickly, it's not always just simply you have an event, and therefore, you recognize a capital gain.
Alex Caswell:Sometimes recognizing that event requires you to make a decision. And what we see as financial planners working with these high net worth individuals, whether they're business owners or tech professionals or whomever, sometimes what stands in the way of them actually making that decision, which could be in the best interest of their finances, is the giant tax bill. Right? And so without them knowing all their different options, without understanding how they can implement that, sometimes to their own detriment, they decide to kinda just, you know, hang out there. Right?
Alex Caswell:So just wanted to mention that. But, Colby, why don't you explain tax laws harvesting since, this is your bread and butter?
Colby Davis:Sure. So we all know that, sometimes stocks go up, sometimes stocks go down, pretty much any investment carries risk. Now, of course, we always want our investments to go up, but inevitably, some of the time they go down. If they go down below the price you wish you paid for them, the cost basis, if you then sell that investment, you have realized the capital loss. And as Chris, you mentioned that at the end of the year, that, loss can be used to offset any gain you realize that year.
Colby Davis:So, what has become, you know, more common over the recent decades is to, you know, we all have heard the virtues of diversification and investing in diversified instruments like ETFs or perhaps you have a basket of different stocks. So, typically, in a given year, some of those, you know, have among a diversified portfolio. Some, stocks or other assets are gonna go up and some are gonna go down. And so tax loss harvesting is a strategy of intentionally selling the assets that have fallen below their cost basis, so that you realize that gain or sorry. You just realize that loss and then buying something else with a similar economic characteristic.
Colby Davis:Now, a hurdle that some people have to get over in their head is people don't like to lose. Right? So oftentimes, if your the stock you own has gone down, clients or investors don't want to kind of admit defeat, so to speak. They don't wanna sell something that they, you know, think is lost. They wanna hold on to it.
Colby Davis:But, you know, in a world where there's 1,000 and 1,000 of stocks and 100 or 1,000 of ETFs that we can choose from, if you, are holding, you know, one ETF investing in US stocks and it's down at a loss, it's pretty easy to sell that and buy a new ETF investing in a similar strategy or sector, doing a similar sort of thing, and therefore, you're not out of the market. We're not recommending that you, you know, get out of the market, to, realize tax tax losses. It's just a way of shifting into different assets while realizing those losses, and those losses can then offset future gains. Now sometimes, some years, maybe you're you don't plan to have any gains. But as we've been kind of alluding to, oftentimes, there's a situation where a client anticipates that in the future, they're going to sell their home or their, their business or, have some other sort of capital, you know, employer stocks that they will be, getting investments in.
Colby Davis:And so it's often good to, look you know, plan ahead of time and anticipate those sorts of capital gain events and, try to offset them with capital loss, tax loss harvesting.
Chris Picciurro:And that's something to consider. You know, we don't want the tax tail to wag the dog. There's no 100% tax rate. So, you know, like Alex said, think about that. One thing to also talk to your financial adviser about and tax professional about our wash sale rules.
Chris Picciurro:Those are special rules for when you harvest the loss and potentially rebuy that. And as we wrap up, you know, you did an amazing job explaining what a capital loss is. In in, you know, taking the motion out of it some emotion out of it sometime. We talk about cash flow versus tax flow. Like, if you if you harvest a capital loss, there's no money coming out of your pocket.
Chris Picciurro:It's just a loss recognized on paper from your portfolio. So that's that's kind of a neat thing about capital loss harvesting. But as we wrap up in the last couple of minutes here, can you tell us about a strategy that you guys have developed called trend, specifically for people with law large capital gains that might say, look, I've got a $1,000,000 capital gain. I'm looking to harvest capital loss and stuff. Sout that legally and ethically, and and this could be not only for taxpayers, but if you're a tax professional, if you're a financial adviser listening to this and you're racking your brain trying to help your client out mitigate these capital gains, this trend strategy is something that you really wanna look at.
Chris Picciurro:But can you guys give us, you know, wrap up the last couple of minutes on what trend is and and and let us know, what would be great for it?
Alex Caswell:Yeah. Let me share kind of some of the, strategic uses that we found for it. So we've been running the strategy for, I don't know, probably longer than I've been here. But when I came on, I, one of the things I noticed is that this strategy really worked well with clients that had very appreciated concentrated individual stock. And the purpose of the strategy was essentially to create diversification and reduce that concentration in a very tax efficient way over time.
Alex Caswell:But more recently, what we've started use using the strategies for is harvesting these losses in anticipation or because there was a large capital in event such as, you know, we had a client who, sold their house in January, recognized capital gain, invested this money. We recognized some of the losses. We did the loss harvesting. And then by the end of the year, their tax bill was significantly whittled out. Right?
Alex Caswell:Now it's gonna be different. It's gonna vary depending on market movements and dynamics. But the general principle here is that if you have a large capital gain sitting in your portfolio or if you're anticipating large capital gain, then this more advanced version of tax loss harvesting, is very, very useful. But I'll allow Colby to kind of explain the the the higher details of how it operates.
Colby Davis:Yeah. So our, strategy that we're calling TREND, which stands for tax tax reduction and enhanced diversification, is a strategy in which, we employ, long short investing to, increase the, increase the degree by which we can, engage in tax loss harvesting. So the problem with, tax loss harvesting as it's traditionally implemented, as I discussed earlier, where you're just invested in stocks and if the stocks happen to go down, you sell them, to realize a loss. That relies on the market basically going down. And, you know, a problem that we often face is that we we invest in a market.
Colby Davis:Markets usually go up. And if at a certain point, you reach a point where nothing in your portfolio is at a loss and it's at such a high gain that you can't make any changes without realizing gains. Now, one what we have found we can do to overcome this problem is that, we can layer or overlay a long short portfolio on top of the, port, the existing portfolio. So say you're just in a 100% invested in stocks, just a handful of ETFs or whatever. What we can do is say you're a 100% stocks, we can use leverage to then go long an additional 50% of stocks and then short 50% stocks.
Colby Davis:Your your net economic exposure to stocks is still 100%. But now whether the market goes up or down, one of the legs of your portfolio of those long short overlays is going to be, trading at a loss, and we can close that position and reopen new ones and then re rinse and repeat this process anew. Now, obviously, involving, in, leverage and short selling is much more complicated, and there's a lot of detail that to this that we can't go into detail right now. But, the basic idea is that without, increasing the, systematic risk of the portfolio, we can create these long shore overlays, which will, you know, as long as the market has a fluctuation of any kind, there's always gonna be something in a portfolio that is at a loss, and we can use that to, you know, realize that loss and offset gains.
Chris Picciurro:And as we wrap up, at what point is specifically for trend, at what point are we looking at for a capital gain, the level of capital gain where this strategy would make sense? And what's kind of the lead time as far as, you know, we're we're here at the end of the year, but let's say someone has a large capital gain event in in February. Is that, you know, is it something that has to be done at a certain time of the year, or what's what's kind of your lead ideal lead time and ideal capital gain, threshold for the strategy?
Alex Caswell:Colby, do you wanna answer this? Maybe maybe I can answer. I think maybe Colby, his Internet connection got a little screwy there. But, yeah, the more time we have to implement this strategy and harvest the losses, the better. Meaning that, maybe something we didn't mention is that capital losses can carry forward on forever.
Alex Caswell:Right? Meaning that if you recognize capital losses this year, you don't have to use them this year. You can use them next year. But if you're kind of in a situation where you're going to recognize a capital gain and you wanna offset that capital gain by the end of the year, the best time is January 1. Right?
Alex Caswell:Because if you recognize that capital gain January 1, you have a liquid portfolio. That portfolio can be invested. Those losses can be harvested. It provides us opportunity of a 12 month runway to essentially implement this strategy and to reduce this tax bill. But as I was mentioning, you can preemptively start running the strategies.
Alex Caswell:So you could kind of you know, in that you may sell business in 2 or 3 years, you already have harvested a decent amount of losses.
Chris Picciurro:That sounds amazing. And, you know, I think that so if if you and and there's there's something about being proactive too. Like, there's nothing wrong with if you like this trend strategy to start creating capital losses, knowing that maybe a year or 2 years down the road, you might have a huge capital gain from you plan to sell your home, relocate, you play you have life events, you have stock options. So, so no. This is amazing.
Chris Picciurro:So well and so, Alex, Colby, thank you so much for coming on. I really, really appreciate it. Again, if you're listening to this, we have a link to both of their information and the specifically, this trend, the strategy that I really, really like. I've been doing my own due diligence on it for about 6 months now. So if you're, again, not just if you're an investor, taxpayer, if you're a tax professional or a financial advisor, reach out to to these guys, and thanks for listening.
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