Artificial intelligence is taking over tax preparation at major brokerage houses, easing the burden on small and large investors. That means less time poring through spreadsheets, looking to save pennies, and more time growing long-term assets.
Traditionally, investors calculated the tax impact of trading losses once per year because it was so complex, often requiring extensive record-keeping. That meant waiting until the fourth quarter, or until brokers mailed a list of transactions in January on IRS Form 1099. Thankfully, high tech has now taken the wheel, according to Kiplinger, with automated tax-loss harvesting doing the math work.
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Federal rules allow investors who lose money on certain securities to deduct part of their losses from taxable income. Most of these calculations come into play with stocks, but index funds, bonds, real estate and even cryptocurrency can meet loss requirements. Instead of doing-it-yourself, automated tax-loss harvesting can now match up those gains and losses daily.
Note: traditional 401(k) retirement accounts can't harvest losses because they are not taxed until distribution.
Automated harvesting is generally free for small investors through popular robo-advisors, requiring just a quick opt-in. According to Kiplinger, the AI harvests when an investor sells assets, including stocks, that have lost value and uses the proceeds to offset gains from other assets. However, these transactions can conflict with the equally arcane wash sale rule, which may change official entry and exit prices of affected instruments.
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JPMorgan Chase (NYSE:JPM) explains the wash sale rule, which triggers when you sell a security at a loss and buy a "substantially identical" security within 30 days. IRS created this market prohibition to "prevent taxpayers from deducting paper losses without significantly changing their market position." Harvesting AI solves this issue by considering wash sales when matching up transactions used to reduce capital gains and/or increase capital losses.
Extensive back-end record-keeping is needed for daily tax-loss harvesting. Kiplinger notes the complexity of this task, citing an example in which a portfolio has 15 securities, each with 15 tax lots, or groupings with the same entry price and time stamp. That equals 225 total lots needing review before any harvesting. Now, imagine how many terabytes are required to examine the thousands of trades done each year by some short-term players.
Harvesting and other broker tech now examine enormous records and match them daily. This adds to an automation trend that started in 2011 when the IRS required brokers to recalculate the security's cost basis in real time to account for wash sales. This is why some investors still scratch their heads, trying to figure out why the prices and profits reported on monthly statements don't match their transactions.
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Direct index strategies have multiplied like rabbits since automated tax-loss harvesting came into popular use. In this scheme, large investors buy stocks of an index directly, and in proportion to the underlying weighting. Harvesting then consumes orders of magnitude more data than Kiplinger's example, capturing losses up to 40% of the portfolio, or "nearly double" common ETF-to-ETF trading strategies.
Despite its promise, the benefits of this artificial intelligence are negligible if small investors don't actively buy and sell stocks. As Kitces.com columnist Ben Hendry-Moreland notes, much of this technology "fails to consider the individual tax circumstances." And he admits that, "in reality, not all investors may benefit from tax-loss harvesting."
Read Next: How do billionaires pay less in income tax than you? Tax deferring is their number one strategy.
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