In a portfolio context, an investor does not need to lose any economic value to claim tax losses. This is the result of two elements—the first is that there exists cross-sectional dispersion across positions within a portfolio—some go up, and others go down. The second is that the taxation of financial assets is based on transactions, not on mark-to-market value. In the exhibit below, we illustrate with a simple example.
Tax-loss harvesting in a long-only portfolio
(1) An investor starts with a portfolio of two stocks – A and B, each purchased at $50 for a total value of $100.
(2) The price of stock A goes up by 10%, and its value rises to $55, resulting in an unrealized gain of $5. The price of stock B goes down by 10% and its value falls to $45, resulting in an unrealized loss of $5.
(3) A TLH program would begin by continuing to hold stock A and selling stock B to realize a loss of $5. It would then replace stock B with stock E using proceeds from the sale to remain fully invested. After harvesting this loss, the economic value of the portfolio remains at $100, while the tax basis falls to $95.
This $5 tax loss can be used to offset capital gains in other parts of the investor’s portfolio. As the portfolio’s economic value is not necessarily equal to its cost basis, an investor can claim tax losses without incurring economic losses.
Tax-loss harvesting with long/short extension
In the next exhibit below, we apply this framework to a 130/30 long/short portfolio. With $100 of investment, an investor can add shorts worth $30 and longs worth $30 on top of the $100 investment. The portfolio’s total exposure is $130 long and $30 short, which still maintains the same $100 (beta one) net exposure.
(4) The same investor holds a portfolio of four stocks – A and B each purchased at $65 for a total value of $130, as well as C and D each sold short at $15 for a total value of -$30. The net exposure remains at 100.
(5) Stock A goes up 10% and its value rises to $71.50, resulting in an unrealized gain of $6.50. Stock B goes down 10% and its value falls to $58.50, resulting in an unrealized loss of $6.50. Stock C goes up by 10% and its value rises to $16.50 resulting in an unrealized loss of $1.50 (shorts lose money when prices rise). Stock D goes down by 10% and its value falls to $13.50, resulting in an unrealized gain of $1.50.
(6) The TLH program selects positions with unrealized losses to unwind and replace. It would sell stock B to realize a $6.50 tax loss and buy (cover) stock C to realize a $1.50 tax loss. Stock E would be bought to replace stock B and stock F would be found to replace short stock C. Stocks A and D would continue to be held as they have unrealized gains.
The economic value of the portfolio remains at $100. At the same time, the cost basis goes down even further to $92, resulting in $8 of realized losses that the investor can use to offset capital gains generated by other investments.
Comparing long-only tax-loss harvesting programs with programs that include a long/short extension yields several interesting observations. On the long side, tax-loss harvesting picks stocks with falling prices. While harvesting losses on the long side, the position’s cost basis keeps falling (as we repurchase at lower market value), but it cannot go below zero. This reflects the fact that as an investor, when you buy a stock, the maximum you can lose is the amount of your initial investment. On the short side, it works in the opposite way. Tax-loss harvesting on short positions picks stocks with rising prices. As the harvesting process unfolds, the cost basis of the position keeps growing (since market value of the closed short position increases), making the short side valuable for tax-loss harvesting, considering that markets tend to rise on average. Having both longs and shorts provides an attractive benefit—losses can be harvested in any market environment regardless of market direction, unlike the long-only approach, where losses can generally be harvested when markets decline.