Tax Loss Harvesting: Tax Alpha with Raul Shah

0:09Raul Shah:We are back with none other than Mr. Raul Shah from Doc Shaw Financials. You know him as one of our very own in-house tax experts who has been helping us all as citizens, as investors, helping us navigate the tax world very astutely and very efficiently. He is the founder, as I mentioned, of Dock Shop Financial, which is a value investing firm that's focused on helping everyday investors and retirees maximize their portfolio growth while protecting all of our wealth from heavy taxation through advanced tax planning. Dock Shop Financial has been around since 2023, and it's generated a 43 % annualized equity return for its clients.

0:58Raul Shah:Raul is also an educator at Johns Hopkins University where he teaches a tax planning course for that community. And I'm very excited to have Raul again on for our monthly chat. Today we're going to be talking tax loss harvesting, but I wanted to, because Raul has been on in the past talking his very successful investments, most noteworthy hymns. But he's got some other announcements and I think updates for us that I asked him to share with our investing community because I think it's helpful to know where these stocks are at and what he's thinking about. So all of that, welcome Raul to another month at Investing Experts Podcast.

1:39Reina, thank you for that warm intro as always. I think this is week four that we've been doing in the tax planning series. And I still get so many emails from people that listen to the podcast and they love it. I have people that just reach out to say, oh, I didn't know XYZ before, and now I'm down the rabbit hole. And that's really the goal of this, I think, segment is just to help people educate themselves and learn for themselves. And Seeking Alpha, I think, is the best community to do that. And so I'm excited to get into the tax planning stuff that we'll talk about with tax loss harvesting, because there's actually a lot of nuance with that strategy that I think a lot of investors aren't necessarily aware of.

2:20But also happy to give an update just on the firm. As you mentioned, we're a value investing firm. So when I work with clients, I always try to put quality in front of quantity. So I don't go out and buy 20 stocks for clients. It never made sense to me. Why would you put money in your 20th best idea. Why not your 19th? And you could apply that same logic and so on and so forth down the chain effectively. So we focus on quality. A few of the names that we own, I've written articles about on Seeking Alpha like HIMSS and ServiceNow and UnitedHealth Group, just fantastic businesses. And I'm happy to talk about them.

2:57These, of course, are not recommendations. I don't know anybody specifically listening in the audience and what your situation is, but I'm a fan of stocks. And so I love talking about this stuff. You know, Hymns is our crown jewel. That's a stock that I've owned personally since 2021. And it's a stock that's been in client accounts since inception. Every time I onboard a new client, I, you know, Hymns is usually the leading stock in their portfolio. And that's just because their growth is tremendous. I think their total addressable market is tremendous. There are risks in that business. You know, anytime you navigate in the healthcare industry, it's always very regulatory.

3:30So it, you know, almost every other week, it seems like there's some news on him saying, oh, they're kind of breached from doing XYZ. So there's never a dull day owning that stock, but I think it's a tremendous business with great unit economics. And I expect it's going to do very well for a long period of time. ServiceNow is another fantastic company. I'm a huge fan of the CEO, Bill McDermott. I've read his book and I just really admire the integrity that he has. And of course, I've never met him personally, but you can get a good glimpse of people when you read their life story and where they come from, especially when it's from humble beginnings.

4:05I was buying that stock. I'm the only portfolio manager at Dock Shop Financial, so I oversee all the accounts. I was placing that stock and client accounts at$98,$95, and even further down. Now we're at almost 150 in six weeks. I always tell people price does not determine value. We've had conversations about this in the past and and you know it's a bit hypocritical for me to come on air and say because the price is going up i'm justified or i'm right um i'm looking at the business valuations and i'm looking at you know the earnings continuing to go up i'm looking at the unit economics of all these businesses continuing to improve especially with united health group they've come a long way in six months and you know that's why the the stock prices uh have risen and why i expect them to continue to rise but but that's the name of the game you know value investing that's why i always help.

4:54Your price and value don't equal each other. If you chase price, you'll lose that game 100 % of the time. If you chase value, you'll win not 100 % of the time, but you'll get pretty dang close.

5:04Raul Shah:As a reminder, as a refresher, what would you say, and again, not to get too far off the tax topic, but just to make a point as a value investor, what would you say are the most salient metrics you would encourage investors to look at without doing the deepest dive possible? Sure. I always look for five things right off the bat. I can analyze pretty much any company if it's worth looking into more within 60 seconds at this point. Revenue, you have to see revenue going up every year. You know, in economics, revenue is really just a proxy for demand. And so if you're a company and your revenue is falling, that means less people want your products.

5:39That's not a good investment. That's not a good company to own. So that's number one. You want to see revenue going up because you want to see more people buying services or products. It doesn't matter how you chop it up. You could be selling more units at a cheaper price or fewer units at a higher price. But what you want is the total demand or the total revenue to be going up. You also want profits to be going up. You want earnings per share to be going up. Technically, there are great investments that don't have earnings per share today. Like, you know, there's companies like, you know, Hymns or Palantir or a lot of these other great companies that are expected to produce ample earnings in the future.

6:12So it's not a hard and set rule. But, you know, you either have to have some prospect of realizing earnings relatively quickly, as in within the next five years, or they already have earnings and they're going up every year. Otherwise, you're just buying a pipe dream. You know, if you're buying a company and their earnings aren't expected to go up until like 20 years into the future. I mean, you got to be kidding. There's a million other stocks out there. You're just losing an opportunity cost. So you want good, solid earnings in your business. And then the balance sheet. There's only two things that matter.

6:41You look at the cash, you look at the long-term debt. Companies are like people. So if you buy a company that has a lot of cash and no debt, the insolvency risk is... You correct me if I'm wrong, but I haven't seen a lot of companies go bankrupt when they haven't borrowed any money. That would be a neat party trick for somebody to pull off. So you want protection. You want margin of safety when you're buying businesses. And you also want cash flow from operations to be going up. That's just the cash you make from the stuff that you sell. And if you only bought businesses that had those characteristics, companies that the revenue is going up, the earnings are going up, the cash flows are going up, there's a ton of cash on the balance sheet and there's no debt, not only would you buy far fewer businesses in life, but you'd have much better results doing a tenth of the work.

7:19It's not easy to manage a portfolio of 30 stocks when you have a full-time job. That's a full-time job in and of itself. And the whole idea always struck me as ludicrous, right? Why put money in my 30th best idea? The only reason that I would ever do that is if I was just trying to have an insurance policy against my own laziness. If I'm not doing enough due diligence on my companies that I feel the need to just keep adding more so that if some go down, some go up and it balances out, that's not really an investment strategy. So those are the things I would say if you're a true value investor.

7:50And the benefits are tremendous. You'll likely make far more money than you ever thought was possible. Owning fewer businesses, doing less work, and getting better sleep. You know, purchase price is very important when you buy stocks. You can't ever pay more than what something is worth because the more in excess you pay for something relative to what it's worth, the more risk you take. And believe me, you're not going to sleep well at night if you take on a lot of risk in investing.

8:13Raul Shah:Speaking of not wanting to take on a lot of risk, how may tax loss harvesting help us kind of navigate those choppy waters of profitability? Sure. Yeah. So tax loss harvesting, right? I always tell people it's very simple to understand. It's a little bit more complicated to know when to use it. So let's define it, right? Tax loss harvesting is just recognizing a loss in order to specifically reduce your taxes owed in a particular year. So let's take a very basic example here. Let's say that you have five, and by the way, we're going to ignore state taxes and all these other, we're just going to focus on kind of the federal tax, capital gains tax, just to make the example easy.

8:58Okay. Let's say that you have no gains in your portfolio. Okay. Tough year. And you've got 10 ,000 in a short-term capital loss. Okay. So you bought a stock in July, you lost 10K in it, and we're at the end of the year. If you sell that, you actually get a tax benefit because you can lock in that loss. Ultimately, in this example, if you had no gains, you would be able to deduct up to$3 ,000 from your income, from your salary. The benefits are not tremendous. It's not like you're going to save hundreds of thousands of in lifetime taxes like you could with Roth conversions. But it's compounding sort of in reverse.

9:42It's the little bit that you save every year that could add up over a long period of time to really good tax benefits. Now, there's, like I said, a lot of nuance, and we'll dive into that in just a second. But at the end of the day, tax loss harvesting is purposefully recognizing a loss, clicking the sell button to lock in a loss. Because until you do that, it's just an unrealized loss, right? It's just a paper loss. It's not a real loss. So you can't do tax loss harvesting until you actually sell it and you recognize that loss. And you're doing it with the intent to save X amount on taxes. If I take it kind of a step further, what a lot of people will do is they will buy a stock and they will sell it specifically to harvest losses if it goes down.

10:30And I tell people tax loss harvesting is not the main goal. Okay, the main goal is making money, right? Like there's a saying we have in wealth management, which is don't let the tax tail wag the dog. That's just a kind of cheeky way of saying don't make saving in taxes the number one priority versus making money, right? It's only if you happen to have made a bad investment or the market goes down that you might want to consider tax loss harvesting. You don't want to just do it for the tax benefits. One of the common mistakes people will do with tax loss harvesting is, let's say that the market goes down and they decide that they want to sell, they own the S &P 500 and they want to sell that ETF to recognize losses.

11:21but they don't recognize that there's an opportunity cost to that because there's essentially the IRS has what's called a wash sale rule. So if you're going to sell a stock at a loss, you can recognize that gain and reduce your taxable income with it or offset your capital gains tax. And we'll use examples in just a second with actual numbers. But there's a window of 30 days before and 30 days after where you cannot have owned that identical security. And that's done to prevent gaming the system. So like, for example, right, if I were to buy a stock and it falls and I have a$10 ,000 loss in it and I just sell it, recognize a loss and then just buy it right back 10 seconds later.

12:05Well, I mean, you could see how that'd be a problem, right? Every time, every day the market goes down, you would just do this over and over and over again. you would remain 100 % invested throughout every day of the year, but you would have racked up thousands of dollars in losses that you would be netting versus your capital gains. So that's why the wash sale rule exists is to prevent that from happening. And we'll talk about one really big nuance with that a little bit later. But again, when you do that, if you tax loss harvest and you save X amount in tax dollars, you also have to factor in that it keeps you uninvested for up to those 60 days.

12:46And so you're sitting out of the market during that timeline. And what if the happens to go up a lot during the time that you have to sit out, like after you sell it? If the market goes up 10 % and you don't save 10 % in taxes, well, then you actually lost money, right? So it's not a perfect science. It takes a lot of planning and it's really only valuable to do it in scenarios where the benefit to you is obvious. Sort of like investing, right? Like, you know, when I'm buying stocks for clients, I'm not trying to buy stocks that I think if everything goes right, the company is going to, the stock price will go up.

13:23I'm trying to buy stocks that if everything goes wrong, the stock is still underpriced, right? And so it's, it's, you have to try to make it really obvious. And that's where these strategies come into play. So I kind of stop here and see if that makes sense and open up the door for any other questions or comments.

13:39Raul Shah:Well, I was going to ask, it may make sense for you to continue on in your explanation, but I was going to ask if there's a real world example that you can think of of a tax loss harvesting that you're happy with that feels like a good example and one where you feel like was maybe too preemptive or something of that nature. Sure. That's a great question. And I'm going to come out as a little bit hypocritical here. So when I look at my own personal brokerage account, I don't really buy index funds or ETFs. I mean, I buy individual stocks. And individual stocks is very difficult to tax loss harvest because the idea, remember, is that if you happen to have a loss, you can lock it in.

14:19And then you can rebuy maybe a similar but not substantially identical security as a placeholder so you aren't sitting out of the market. You're still invested, but you get to recognize that loss. The problem when you own individual stocks is how do you find an 80 % replica of what you own? It's like people will say, if I own Coca-Cola and it's at a loss, I could sell it and then maybe buy Pepsi. But the problem with that is that they are still two different companies. Just because they both sell beverages doesn't make them the same company. It's much more valuable when you own an ETF. Because if you were to own, let's say, I'm just using these as examples.

15:00If you were to own Vanguard's VOO, which is the S &P 500, and you sold it to lock in a loss because the market's down, but you have to stay invested, so you buy back maybe the Russell 1000. Those indices are different, but you're staying invested, and they're close enough that if the S &P is going up, the Russell 1000 is probably going up too. So you're still capturing all the upside, but you're locking in that downside loss. You just can't do that as easily with individual stocks. And it's funny because you'll have people who, a lot of times people only tell half the story. They'll always tell you, they'll sell you on the tax benefits, but you always have to remember that opportunity cost.

15:41And that's why doing it with individual stocks is sometimes not the best idea because you can't really remain invested to something that's an individual stock, something that's similar to it, but also different, if that makes sense. And if we kind of use an example here, let's just say, let's go back to ETFs, like you own the S &P or something like that. Let's say for the year you recognize$10 ,000 in short term capital gains. Okay. And let's say that you have 20 ,000 in short term capital losses. The IRS uses what's called a like for like matching system. So short term capital losses offset short term capital gains first.

16:21And if there's excess remaining, then those short-term capital gains will offset, then the short-term capital losses will offset long-term capital gains. And if there's still in excess, then you can use up to$3 ,000 to offset your ordinary income. And if there's still excess left, then it carries forward to the next year and indefinitely. So if we run through an example, right? I have$10 ,000 in short-term capital gains, and I've got 20 ,000 in short-term capital losses. So right off the bat, all my short-term capital gains, the tax is going to be wiped clear because I've got$2 in loss for every$1 in gain on a like for like basis.

17:06So after I net that out, I've still got$10 ,000 in short-term capital losses. So if I have, let's say, a$5 ,000 capital gain, that capital gain gets cleared out, and I still have $5 ,000 in short-term capital losses. And then I can take$3 ,000 of that, deduct that from my income. So if I made$100K for the year, now my taxable income is only$97K. And then I've got$2 ,000 left that I can carry forward to the next year, which would offset any capital gains in that year on a like-for-like basis. And if something's left over, then it would apply to your ordinary income. A big misconception people will get is that they think that you can only deduct$3 ,000 a year in tax loss harvesting.

17:49And that's not true. You can only deduct up to$3 ,000 on your income, but you also can offset your capital gains, and the excess will just carry forward indefinitely. So if you have a horrendous year and you lose, I don't know,$200 ,000 or something like that, you're going to use up all of those losses. You may not use them all up in one year, but you will use them up, hopefully, if you do things right over your lifetime. But that's one really big misconception that people have. I don't know, Raina, if you've heard that before, the$3 ,000 rule, but a lot of people will get that confused.

18:23Raul Shah:Yeah. I feel like I've brought this up before, but when I was starting the Cannabis Podcast, there was a lot of discussion about tax loss harvesting at the end of those years with people's portfolio. I remember some highlights from that. Any other caveats you would add to a chock full caveat conversation? Yeah, absolutely. One of the things that always trips people up is not necessarily the wash rule, right? That 30 day window before and after where you can't own the identical or essentially identical security because it will disallow your wash or disallow your loss. One thing that trips people up all the time is that applies to also dividends.

19:04So people have drip programs set up, right? Dividend reinvestment programs where they're just automatically reinvesting their dividends into the same security. And so what happens, you probably had this in your portfolio right before, where you'll buy a stock that has a dividend. You'll sell the stock before the next dividend is paid. And then the dividend check comes in. And you're like, oh, how do I own that stock again? It's because it was automatically reinvested. And so that counts. That will trigger the wash sale rule. So people will sell something. They locked in the loss. And then like a week later, they'll have their dividend check deposit, but it's reinvested in that security, which counts as you buying back that security again.

19:43And then that disallows your loss. So you have to be very careful with that because that trips people all the time. You got to turn that feature off if you're specifically trying to tax loss harvest. The other thing that trips people up too is that tax loss harvesting only applies in brokerage accounts, right? It doesn't make sense. It wouldn't apply in an IRA, a Roth IRA, traditional IRA, 401k, because those are all either tax deferred or tax free accounts. So there's no such thing as tax loss harvesting in those accounts. So what people think, they think they'll try to trick the system, which you can't do that, by the way.

20:14And you should, nor should you ever try, always follow the rules. But what people will do is they will sell a stock in their brokerage or sell an ETF and they'll lock in that loss. And then they think they're slick and they go buy it in like in their Roth IRA. It doesn't matter what account that you are selling and buying from, if you rebuy the same security, period, you're going to disallow the laws. So those are kind of the two really big nuances that if you do try to execute that, you really do need to be aware of. And then it's just really just the mindset. It's going in knowing that I'm not trying to lose money.

20:48I'm only going to tax loss harvest if there is some economic benefit to me that exceeds the opportunity cost of just remaining invested. Right. So there it's not just like you do it automatically every year. You have to actually think through and run the numbers on when it's appropriate, you know, when when it really makes sense. And then the last little nuance that I will leave everybody with is that when you tax loss harvest, you sell something in a loss, you lock in that loss, and then you rebuy something similar. What's happened is that you're likely buying something now at a much lower cost basis.

21:28So again, yes, you recognize that tax saving from tax loss harvesting, but because you're now taking those cash proceeds and buying something that's similar but different at a much lower price, whenever the market recovers, your cost basis being lower means that your future tax bill is going to be higher. So you have to calculate that with your overall estimation of if you make out better or not by tax loss harvesting. So it's not just like a one-time cure. So just to kind of quickly recap, right? So tax loss harvesting, essentially what we're doing is we are locking in a loss to gain some kind of a tax benefit in our brokerage account while simultaneously trying to remain invested to capture the upside of the recovery of that stock or similar stock or ETF, whatever, while also making sure that we do not trigger the IRS loss sale rule, which can be triggered by dividends it could be triggered by buying the same security in in your brokerage or a different account and then ultimately we have to run the numbers to figure out if it's advantageous it's not a strategy that's going to save hundreds of thousands of dollars in taxes over your lifetime like i said before but it is something that if you do strategically you can save a meaningful amount and it's something that you know investors should consider a word a worthy trick in the toolbox Exactly.

23:01Yeah.

23:01Raul Shah:Well, appreciate this conversation. Another very edifying talk. Anything else to add before I let you go today? No, I think this was great. I think the only natural next episode would have to be tax gain harvesting, which is way better, in my opinion, than tax loss harvesting. So if you like this episode, you're going to love that episode. And it's great, actually, for retirees. So a lot of people that listen to the podcast in that phase of life, you guys got to hear that one. Perfect. Something to look forward to in October. If you like loss, you're going to love gain. Looking forward to that.

23:35Raul Shah:We'll talk to you soon and enjoy September. Thank you. You too. Just a reminder, anything you hear on this podcast should not be considered investment advice. This is for entertainment purposes only, and you should seek advice from a licensed professional before investing. If you enjoyed the episode, leave a rating or review on your favorite podcasting app, and we'll see you soon with a new episode.

23:591