What are the California State Tax Implications of Tax Loss Harvesting?
Tax loss harvesting in California is an investment strategy where one uses to offset capital gains and reduces tax liability on paper loss you make from selling bad investments. The federal application of this technique varies widely by state, with tax consequences. As a California investor, you would do well to understand the effect of tax loss harvesting on your state tax burden. California tax policy varies from federal tax law on several key fronts.
Understanding Tax Loss Harvesting
Let’s review tax-loss harvesting fundamentals before we get to California tax considerations. Investors sell investments at a loss to apply against gains from other investments. This allows you to keep taxable income and the tax bill as small as possible. If capital losses exceed capital gains, up to $3,000 ($1,500 if married filing separately) in losses may be deducted against ordinary income at the federal level. This amount allows the remainder to be carried over to next calendar year.
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While This Policy Is Beneficial At The Federal Level, The Tax System Of California Presents Unique Challenges.
California Capital Gains and Losses Taxation
Like the Federal government, which collects long-term capital gains favorably (0%, 15%, or 20% if MAGI less than certain thresholds depending on income) statewide California classifies all capital gains as ordinary income. Hence, both long-term as well short-term capital gains are taxed for equal tax levels of wages and other income, from 1% to 13.3% of income group of the person.
California follows federal law on capital losses in terms of netting gains and losses for these purposes, as well. That said there are vast disparities when it comes to losses though.
California State Taxes to Take Into Account MajorSMSA
1. No Preferential Long Term Capital Gains Tax Rates
California does not provide a reduced tax rate on long-term capital gains. Since all long-term capital gains are taxed as regular income, tax loss harvesting may be less successful than it is federally. However, it does serve to decrease taxable income, particularly to high-income earners who are subject to California’s highest tax bracket.
2. Carryforward of Losses
California follows federal rules on carryover of excess losses. When your total capital losses exceed your capital gains and the deductible limit of $3,000, you can carry over the unused amount to future tax years. California does not conform to federal rules allowing losses to be carried back to past years, as some states do.
3. No Loss of Excess Net Capital Over $3,000 Against Other Income
Like federal tax rules, California limits the deduction of net capital losses to $3,000 per year against ordinary income. Excess losses are carried over.
4. No State-Specific Wash Sale Rule, But Federal Rules Apply
California does not have its own wash sale provision but follows the federal wash sale provision. The latter disallows investors from claiming the loss when they purchase the same or similar security within 30 days preceding or after the sale. Since California conforms to this provision, tax filers should be cautious when applying tax loss harvesting tactics to avoid disallowed losses.
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5 Federal impact on Net Investment Income Tax (NIIT)
Individuals who are single and above $200,000 in income, as well as married and above $250k in income face an additional 3.8% Net investment Income Tax (NIIT) on investment gains at the federal level. Although California does not levy one at the state level, tax loss harvesting can be an indirect way of reducing federal NIIT liability for California filers.
6. SALT Cap Impact (Exclusion of State and Local tax Deduction
At the federal level, the cap on the State and Local Tax (SALT) deduction is $10,000 which means California residents will be forced into a dollars-for-deductions choice when it comes to deducting state tax on their federal returns. With the exceedingly high tax rates in California, it is greater importance for tax filers that can’t itemize and take state tax deduction on their federal returns to use tax loss harvesting to reduce taxable income.
Optimizing Tax Loss Harvesting in California
Although California does not provide preferential long-term rates of taxation on capital gains, investors here are still able to maximize tax loss harvesting. Some best practices are outlined as follows:
Harvest Losses During High-Income Years: In case of a high-income year, you can sell investments at a loss to decrease taxable income and your tax burden.
Be Strategic about Carryforwards: Although California does allow carryover of losses, utilize them during years when you are expecting high capital gains.
Watch the Wash Sale Rule: Don’t buy the same or very similar securities again within 30 days to allow losses to be recognized.
Take municipal bonds into account: California municipal bonds provide tax-free income, and this can be an effective strategy combined with tax loss harvesting to save on state taxes.
Conclusion
Tax loss harvesting is a useful tool and California’s use deviates from the federal approach. The state taxes capital gains as ordinary income, follows federal wash sale regulations and has a cap on deductibility limit to net capital losses, which means what investors do is important. Though high tax brackets in California provide less of an offset from tax loss harvesting, tax harvesting still can deliver substantial tax savings if properly implemented.
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If you are a California investor, having a tax pro at the helm can be immensely beneficial in helping you design a tax loss harvesting plan that meets your objectives and also lowers your state tax bill.