39. Winter Harvest

It's December, and it's time for winter harvest.

And I'm not talking about pumpkins or other vegetables. I'm talking about losses.

Each December I look at my portfolio and search for losers. This year, my foreign investment fund, FSIVX, did an excellent job tracking all non-US economies, with minimal annual expenses (less than 0.1%), and together with the rest of the world economy lost about 10% of its value. I bought this fund on the last day of December 2010 - pretty bad for an annual performance! But the reason I've just sold all of it is not because I decided  to get out of foreign markets. Remember - once you set a course, you need to stay with it. "Selling your losers and buying winners" is the same as "Selling low and buying high".

But, selling now has a huge tax advantage: all the losses can be realized as short-term capital loss, the best kind of capital loss. It can offset not only short-term capital gains, which are taxed at your marginal income tax rate, but also your ordinary income (up to $3,000 a year). And whatever you don't use in 2011, you can carry over indefinitely, to offset gains in upcoming years. In my case, for every $10,000 of loss I harvest I expect to get about $3,800 back from the IRS. Not a bad deal!

Once you sell a losing asset to harvest loss, you're left with two problems: a pile of cash, and a hole in your investment strategy. After all, I do want to be invested in foreign markets, in more or less the same amount of cash I've just raised.

What you don't want to do is to go back and buy the same investment (FSIVX, in my case). If you do it within 30 days, the IRS considers it a "wash sale", and all the tax advantage goes up in smoke.

But there's a nice loophole: you can invest the money in a similar but not identical fund without triggering a wash sale. As long as I pick a fund that doesn't track the same index as FSIVX does ("Morgan Stanley Capital International Europe, Australasia, Far East Index"), and is managed by the same company, the IRS considers it a different investment. I chose ACWX - very similar, almost identical performance to FSIVX, but tracking "MSCI All Country World Index except US" and managed by a different company. It's not my favorite fund, their expenses are higher, but they'll do - for 30 days. When I rebalance my portfolio in January (at least 30 days from now), I'll switch back to FSIVX.

To sum up, this is the schedule I propose for the tax-savvy investor:

• In December, before year end, harvest losses: sell enough losers to cover any capital gains you might have, and to offset at least $3,000 of income. The end-of-the-year timing guarantees that these losses will be used in the current tax year. Make sure you choose equivalent but not identical funds: this way you keep your financial plan and gain the maximal tax benefit. 
• In January, at least 30 days later, rebalance and switch back to your investment plan's funds. 

Happy Harvest!