The term “tax swap” most commonly refers to the practice of applying a capital loss on one asset to offset a capital gain on another, minimizing the taxation on investment income. But it can also describe a taxing authority that reduces one type of tax and increases another in an effort to raise revenue without creating an undue burden on taxpayers.
These different types of tax swaps can have varying implications as to how much you might pay in resulting taxes. If you understand the differences and how they work, you can minimize a tax hit and avoid penalties.
Definition and Example of a Tax Swap
A tax swap typically means selling a stock or security that’s underperforming and claiming a capital loss on the transaction. You can carry this loss over and subtract it from your taxable capital gains income if you then purchase a similar, better-performing security, and proceed to sell that to realize a capital gain.
For example, you might lose $5,000 when you sell Stock A, but Stock B earns you $6,000 when you sell it within the same year. You can deduct that $5,000 loss from your gain, resulting in a taxable capital gain of just $1,000.
Now let’s say that you lost $7,500 on Stock A. You still earned $6,000 on Stock B. You don’t necessarily lose that remaining $1,500 loss because the Internal Revenue Code (IRC) allows you to carry that loss over to apply to your regular income, up to $3,000 a year. You can even carry that $1,500 loss over to future tax years if you don’t have regular income. But you must apply your loss to your capital gains income first.
The limit of excess loss that you can claim to lower your income is $3,000 if you're single, or $1,500 if you’re married but filing a separate tax return.
Alternate name: tax-loss harvesting
How Does a Tax Swap Work?
A tax swap is usually two transactions: You would sell the losing investment in the first transaction, then you can turn around and purchase a similar, higher-priced investment in the second transaction.
The type of loss you have will impact the result of a tax swap. Short-term capital gains are typically taxed at a higher federal income tax rate than long-term capital gains.
This tactic works well when you’re sitting on an investment that’s showing a loss, although you haven’t actually felt the dollar pinch yet. Capital losses occur when you sell an asset for less than what you invested it in. A capital gain occurs when you sell it for more.
Your $5,000 loss on stock A might be the result of paying $10,000 for that stock when you first purchased it, but it’s only worth $5,000 today. This loss isn’t reflected in your bank account, but rather in your investment portfolio. You don’t have a cash loss until you actually sell the asset, and you can claim that as a capital gains loss because it’s now a cash loss. You would receive no tax benefit if the losing stock just kept sitting in your portfolio exhibiting death throes.
Your portfolio won’t have a loss, either, because you’re replacing that iffy asset with another that’s better performing. Thus the term “swap.”
You can make a tax swap literally up until the eleventh hour of the tax year and, in fact, most investors reserve it for end-of-year tax planning. The practice is often referred to as “harvesting" your losses because you’re effectively gathering them up for tax purposes.
Disadvantages of Tax Swaps
It might sound like a perfect plan, but tax swaps have their pros and cons. It can end up actually costing you money if you perform the transactions incorrectly. You must be careful not to run afoul of IRC “wash sale” rules.
The key term in a successful tax swap transaction is buying a “similar” stock or asset. You can’t purchase what the IRS refers to as a “substantially identical stock or security.” For example, you can sell a stock you held in Pinterest and purchase stock in Facebook because they’re similar but they’re not the same company, but you couldn’t buy other Pinterest stock. Your loss will be disallowed if you do. You must then add the disallowed loss to your basis in the new asset, effectively postponing any tax benefit until such time as you sell the second asset.
You can sell a stock and buy another in the same industry. The wash sale rule is only triggered when you sell and buy stocks in the same company, although the transaction isn’t necessarily safe if you don’t.
By definition, a wash sale occurs when you replace your losing asset with one that’s substantially identical, and you do so within 30 days before the sale day or 30 days after. The rule prevents investors from selling a tanking asset, claiming the loss for tax purposes, then turning right around and buying the same asset back again. The rule also applies if your spouse or a corporation you control purchases the substantially identical asset.
Another potential drawback to tax swaps is that you’re not purchasing the same stock or security, but only something similar. It’s always possible that your newly purchased asset will decrease in value after the transaction, while your sold asset suddenly inhales new life and begins thriving…but you don’t own it anymore.
Always check with a tax professional before you attempt a tax-loss harvest and perhaps with an investment counselor as well. Don’t jump in unless you’re fully armed with all the necessary understanding and information.
Another Type of Tax Swap
State and local tax authorities can get in on the tax swap concept as well, but the process is actually quite different when they do it. A tax authority or government might want to repeal an existing tax for any number of reasons. Maybe it’s not raising the expected revenue or it’s earned a lot of disfavor among voters. But the authority still needs revenue, so it replaces Tax A with Tax B. Sometimes it might drastically reduce the Tax A rate while hiking the Tax B rate.
These types of swaps might occur between two state taxes or perhaps one local and one state tax. The tax authority does not have to be the same for both.
Texas attempted this type of tax swap in 2019, but voters rejected it. The idea was to increase the sales tax by 1% while correspondingly lowering property taxes earmarked for school districts.
- A tax swap typically begins with selling a money-losing stock or security, then claiming a capital loss for the difference between its purchase and sales price.
- The loss of a tax swap can reduce capital gains earned on a subsequently purchased asset, resulting in tax savings.
- The IRS prohibits the tax swap practice between “substantially identical” securities. They can be similar, but they can’t be the same.
- State and local tax authorities will sometimes reduce or eliminate an unpopular tax and hike another tax in another version of a tax swap.