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Tax-loss selling is not as easy as it looks. I’m referring to the practice of selling in December those stocks you hold at a loss, in order to offset the capital gains you’ve already realized and on which you will otherwise have to pay tax. While this seems straightforward, it quickly becomes complicated.
That’s because of the IRS’s so-called wash-sale rule, which prevents you from using the tax loss of any stock you’ve sold if you buy it back within 30 days. That’s something you would want to avoid, since previously beaten-down stocks have some of their best weeks of the year once tax-loss selling abates. Much or all of that rebound takes place when the wash-sale rule prevents you from holding these stocks.
This is illustrated in the chart below, which reflects monthly data back to 1926. Notice that the trailing year’s worst-performing stocks continue to lose money in December, but stage a strong rebound in January. To put their strong January returns in context, consider that on an annualized basis it’s equivalent to a 55% gain.
The key to navigating through these obstacles is to find another security that is closely correlated with the stock whose tax loss you want to harvest. You would want to take the proceeds of the sold security and invest it in the correlated one for the 30 days of the wash-sale rule, and then reverse the transactions. Insofar as your replacement stock performs as well as your sold stock, you will forfeit no investment gain while also producing a nice tax benefit.
A good place to start your search for a correlated security is the “Correlation Tracker” available at the Select Sector SPDR website, which shows you the correlation coefficient between the stock you’re thinking of selling and each of the 10 “Select Sector” SPDR ETFs. The reason it makes sense to start your search with these ETFs is that the bulk of a particular stock’s return can be explained by the performance of its industry.
To understand the statistics this website reports, keep in mind that the correlation coefficient will be 1.0 if there has been a perfect correlation between the stock in question and a SPDR ETF. A 0.0 coefficient means there has been no correlation.
For purposes of the strategy to beat the wash-sale rule, choose a SPDR ETF with a correlation coefficient of above 0.7. From a statistical point of view, that means you’re finding a SPDR ETF whose gyrations explain or predict at least half of your security’s movements.
An alternate approach would be to find an individual stock in the same industry that you also find attractive. For each stock in the table below, I turn to the investment newsletter database my firm maintains to find another stock in the same industry (same two-digit SIC code) that is most highly recommended by the top performing newsletters I monitor.
The table contains the 10 stocks in the S&P 500 with the worst year-to-date returns. It also shows the SPDR ETF that each of them is most correlated with over the last three years.
|
Stock |
Year-to-date return (through 12/2) |
Most highly-correlated Select Sector SPDR (with correlation coefficient in parentheses) |
Newsletters’ most-highly recommended stock in same industry (per 2-digit SIC) |
|
Norwegian Cruise Line Holdings NCLH, +3.46% |
-59.9% |
XLF XLF, +1.22% (0.82) |
Royal Carribean Group RCL, -1.98% ] |
|
Occidental Petroleum OXY, +13.42% |
-58.9% |
XLE XLE, +5.45% (0.83) |
Exxon Mobil XOM, +3.66% , EOG Resources EOG, +10.03% |
|
Carnival Corp. CCL, +2.49% |
-57.9% |
XLF (0.78) |
Royal Carribean Group |
|
TechnipFMC PLC FTI, +9.61% |
-56.9% |
XLE (0.85) |
IBM IBM, +2.90% |
|
Marathon Oil MRO, +10.66% |
-54.9% |
XLE (0.87) |
Exxon Mobil, EOG Resources |
|
Diamondback Energy FANG, +12.67% |
-54.8% |
XLE (0.85) |
Exxon Mobil, EOG Resources |
|
American Airlines Group AAL, +1.93% |
-48.0% |
XLF (0.77) |
Fedex FDX, +0.74% |
|
Apache Corp. APA, +10.48% |
-48.0% |
XLE (0.83) |
Exxon Mobil, EOG Resources |
|
National Oilwell Varco NOV, +8.34% |
-47.3% |
XLE (0.78) |
IBM |
|
United Airlines Holdings UAL, -1.34% |
-47.0% |
XLF (0.82) |
Fedex |
Note carefully that the wash-sale rule only applies to stocks whose losses you are hoping to harvest for tax purposes. If you own a stock with a large gain and want to pay tax on it in this taxable year, you can sell it and then immediately repurchase it.
I mention this because of the concern many of you have that tax rates will be higher in coming years, which might make it preferable to pay taxes on your accrued gains at today’s lower rates. Yet even if rates are higher in coming years, it still might make sense to hold rather than sell now and pay the tax. That’s because until you realize any gain you are benefitting from the compounding effect of the amount you’d otherwise have to pay in taxes.
Mark Hulbert is a regular contributor to MarketWatch. His Hulbert Ratings tracks investment newsletters that pay a flat fee to be audited. He can be reached at mark@hulbertratings.com
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