GameStop (GME) is nowhere near the price level it was at the end of January as the stock’s meteoric rise captivated the country in a groundbreaking, Reddit-powered short squeeze.
The shape of the stock chart — a giant M — and volume mean that a lot of people bought GameStop at far more than the current market price of around $50 as of Friday.
In the current casino-like dynamics of the stock market, many investors might decide to ride the table and win their money back, hoping for a turnaround in the stock price.
But there’s another strategy frequently used to make lemonade from the market’s lemons: tax-loss harvesting. Though it’s too late to use a “meme stock” trade for the return you have to file this spring, it’s a strategy you can use for 2021 on your 2020 year return.
“For every investor who made a profit on meme stocks like GME and AMC, there are many others who are now in the red,” WealthFront CPA Toby Molina wrote in a note. “I know from experience that it doesn’t feel good being on that side of the volatile market, but there are a few things you can do if you recently lost money while day trading.”
Here’s what it is and how it works.
Realizing a loss to offset your income
An investor doing their taxes either takes a standard deduction or itemized deductions. Often, tax preparers — or tax software — will do both and see which is most advantageous.
Investors can use losses to offset gains in the market, which reduces taxes owed. If they don’t have any gains to offset, they can use that money to offset taxes on ordinary income like wages, up to $3,000.
Imagine you bought $5,000 worth of stock and sold it two weeks later for $4,000 because you decided you didn’t like it anymore and wanted to cut your losses.
You’ve realized a $1,000 loss by selling, and you can subtract $1,000 from your taxable income. Which part of the taxable income depends. If you have any short-term capital gains — gains from stocks that you’ve held for less than a year — having losses can be useful.
Because short-term capital gains are taxed as ordinary income rather than at capital gains rate, which is much lower, people will often use losses — or even search for stocks to sell at a loss — to lower the amount of taxes owed.
So say you have that $1,000 loss but you also sold some stock you had for six months for a gain of $2,000. You can subtract that $1,000 (loss) from the $2,000 (gain) and pay taxes on $1,000.
If you don’t have any short-term gains, you can use long-term gains instead. And if you don’t have long-term gains, you can subtract your loss from your ordinary income. If the loss was bigger than $3,000, you can use whatever you couldn’t offset for future years.
“Investors might be surprised to learn that losses can actually be a good thing when it comes to your taxes,” said Molina. “If you’ve already sold your investments at a loss or are planning to, you can harvest those losses and use them to offset any capital gains you may have from other investments.”
According to Maryland-based CPA Mark Stafford, this is usually done at the end of December. Losers are sold to offset the winners when a better picture of the year has come into focus.
But if you know you want to close down a position you can do it at any time.
No wash sales — and a popular index fund trick
One thing you cannot do is realize a loss and then buy the same stock or fund back right away. That’s called a “wash sale” and you don’t get any benefit from it come tax time. The rule is you have to wait 30 days if you want to recognize the loss before buying the same thing again.
For index fund investors this is especially interesting. Thanks to roboadvisor platforms, tax-loss harvesting is increasingly popular and automated. But most people don’t want to wait 30 days to avoid a wash sale and harvest the losses. The way around this is to use a similar investment that’s not the same.
Imagine two elevators side by side representing two funds that rise and fall with their indexes. One is Vanguard’s VTI (VTI), which follows the CRSP U.S. Total Market index, and the other is iShares’ ITOT (ITOT), which follows the S&P Total Market Index. These two funds are really, really similar and most investors wouldn’t notice the difference. (This chart tracks both funds’ performance over the past five years; the lines are on top of each other.)
If the elevators fell 10 floors in a market correction, an investor could simply step across to the other one, selling one fund and buying the other. This would realize a loss to be used to offset a gain or ordinary income while getting back into the market at the same time with effectively the same investment. This also reduces uninvested days — which is key because you never know when the good days will come.
But there’s one important thing in this type of tax-loss harvesting when dealing with funds: The funds have to follow different indexes. Though VTI and ITOT are nearly the same, they track two different indexes.