Four Strategies for Reducing Capital Gains Taxes on Investments

As we approach the end of 2023, some of you may be looking at a combination of gains and losses in your portfolios. While the S&P 500 index has enjoyed a good year thanks to the returns of the so-called Magnificent Seven stocks, many other stocks haven’t seen their prices rise. (The S&P High Yield Dividend Aristocrats index was down year to date at the end of November, for instance.)

If you are among those who have gains and losses from investments held in your taxable accounts, you still have time to reduce your 2023 tax bill. Here are four strategies for doing so:

1. Offset gains with losses. The tax code allows you to offset gains realized in a calendar year with losses realized the same year. Long-term losses offset long-term capital gains first. Short-term capital losses offset short-term capital gains first. If you have excess short-term (long-term) capital losses, they can then be applied to long-term (short-term) capital gains. Any net excess capital losses exceeding $3,000 can be carried over to future years. (You can also apply net excess losses from prior years to this year, as long as you don’t exceed the $3,000 limit.)

2. Harvest losses. Tax-loss harvesting involves purposely selling an investment that’s fallen since purchase to realize a loss for tax purposes. It is similar to the first strategy with the exception that you are not specifically trying to pair gains and losses. Tax-loss harvesting can make sense if the investment is close to meeting your sell rules and you want to lock in the losses this tax year. You can also use it to claim losses in specific lots of an investment that you bought on different dates (e.g., through dollar-cost averaging). If you plan on repurchasing the investment after 30 days to avoid triggering the wash-sale rule (see below), be aware that your new cost basis depends on the repurchase price. If the repurchase price is lower than your original cost basis, you could incur higher capital gains taxes in the future.

3. Donate the investment to charity. Donating an investment held in a taxable account that has risen in price since purchase gives you two positives. First, you avoid paying any capital gains taxes on the investment. Second, you can write off the full market value of the donated securities as a charitable donation. The big caveat to this is that your total deductions (charitable deductions, state and local taxes, mortgage interest, etc.) must exceed the standard deduction. The standard deduction in 2023 is $27,700 for married couples filing a joint return and $13,850 for those who are single.

4. Gift the investment. When an investment, such as a stock, is gifted to someone else, the person making the gift avoids paying capital gains taxes on the investment. However, the person receiving the investment also receives your cost basis. This can result in a potentially higher tax bill for the person who received the gift, depending on when they eventually sell the stock. (A more tax-efficient way could be to bequeath the investment as part of an estate. Doing so results in a “step up” of the cost basis for the person inheriting the investment, instead of the cost basis being based on when the deceased bought the investment.)

Be Careful of the Wash-Sale Rule

The wash-sale rule prevents investors from realizing a loss and then buying or acquiring a “substantially identical” investment within 30 days. If the wash-sale rule is broken, the realized loss cannot be claimed for tax purposes. The realized loss can, however, be used to adjust the cost basis of the new position.

The two big keys are the 30-day window and the “substantially identical” wording. You cannot buy call contracts on the sold investment or add the investment to another account—e.g., an individual retirement account (IRA)—within 30 days and still claim the loss. However, you can turn around and buy a similar investment, such as shares of a competitor or a slightly different fund. An example of the latter would be to sell a small-cap value fund and then buy a different small-cap value fund. (Buying a different share class of the same mutual fund does not count.)