Capital gain tax is a tax that is levied on the profit you make from the sale of a capital asset, such as stocks, real estate, or a business. If you sell a capital asset for more than you paid for it, the difference between the sale price and the purchase price is considered a capital gain, and you may be required to pay capital gains tax on the profit.
Capital loss harvesting is a strategy that involves offsetting capital gains with capital losses in order to reduce the overall amount of tax you owe on your investment income. In the United States, capital gains and losses are classified as either short-term or long-term, depending on how long you have owned the asset before selling it. Short-term capital gains and losses are those that arise from assets that you have held for one year or less, while long-term capital gains and losses are those that arise from assets that you have held for more than one year.
Here is a scenario in which a person has a $1 million dollar gain from exercising stock options in a private company, but does not sell the stock and is able to offset the gain with stock investment losses:
- John has been working at a private company for several years and has been granted stock options as part of his compensation package. The company is not publicly traded, so the value of the stock is not readily apparent.
- Recently, John decided to exercise his options and buy 1,000 shares of the company's stock at a price of $1,000 per share. At the time, the company was valued at $3 million, so the stock options were granted at a price that represented a 3% ownership stake in the company.
- A few years later, the company has grown significantly and is now valued at $9 million. As a result, John's 1,000 shares are now worth $9,000 per share ($9 million valuation / 1,000 shares).
- However, John decides not to sell the shares because he believes the company has further potential for growth and wants to hold onto the stock for the long term.
Even though John has not sold the stock, he still has a taxable event when he exercises the stock options and acquires the shares. The difference between the exercise price and the fair market value of the shares at the time of exercise is considered a "bargain element" and is subject to tax as a taxable compensation. In this case, John has a bargain element of $8,000 per share ($9,000 per share fair market value - $1,000 per share exercise price), for a total of $8 million in taxable compensation ($8,000 per share x 1,000 shares).
However, John also has some other investments in stocks that have not performed as well. For example:
- John has a portfolio of 500 shares of XYZ company that he purchased for $50 per share, but the value has decreased to $30 per share.
- As a result, John has a capital loss of $10,000 ($30 per share x 500 shares - $50 per share x 500 shares).
Under normal circumstances, John would be required to pay capital gains tax on his $8 million gain from the exercise of the stock options. However, John can offset some or all of his capital gain by using his capital losses from the sale of the XYZ stock. Specifically:
- John can use his $10,000 capital loss to offset his $8 million capital gain, resulting in a net capital gain of $7,990,000 ($8 million - $10,000).
- It's important to note that John can only offset his capital gain with capital losses of the same type. Since his $8 million gain is a short-term capital gain (since he held the stock options for less than one year), he can only offset the gain with short-term capital losses. If John had a long-term capital loss instead, he would not be able to offset his short-term capital gain with it.
- In addition, John can only offset up to the amount of his capital losses. If his capital losses exceed his capital gains, he can use the excess losses to offset up to $3,000 of ordinary income per year, and carry any remaining losses forward to offset capital gains in future tax years.
Overall, capital loss harvesting can be a useful strategy for minimizing the tax liability on capital gains, especially when you have gains from the sale of one asset and losses from the sale of another. By offsetting your gains with losses, you can reduce the overall amount of tax you owe on your investment income. It's important to carefully track your capital gains and losses and to consult with a tax professional to ensure that you are taking advantage of all available tax strategies to minimize your tax liability.
