SEM217: Ben Davis, Paraport: Tax Loss Harvesting Optionality

Tuesday, April 25th @ 11:00-12:30 PM, 639 Evans Hall (RECORDING)

The tax law confers upon the investor a timing option – to realize capital losses and defer capital gains.  Investment managers offer tax loss harvesting strategies that systematically utilize this option to deliver after-tax returns in excess of tax oblivious strategies. The question of optimal exercise policy for this option was first taken up by Constantinides (1984) who showed that, when long- and short-term tax rates are equal, perfect substitute securities exist, and trading occurs at 1-year intervals, the optimal policy is to immediately realize losses and defer unrealized gains.  More recently, Khang, Cummings and Paradise (2022) examined the impact of loss harvesting frequency, from annual to daily, on the performance of passive-indexed tax loss harvesting.  The authors conclude that daily frequency has the maximum effectiveness in all volatility environments, assuming the existence of perfect substitute securities.  On the other hand, Israelov and Lu (2022) argue that the IRS wash-sale rule creates a barrier to re-investment such that investor should be selective about when to harvest a loss.  They present a trigger-based loss harvesting policy based loss depth determined by stock volatility and supported by extensive Monte Carlo simulation. Here we extend this line of reasoning by applying stochastic process theory to prove that such a trigger-based policy is optimal for a stylized, continuous time model of tax loss harvesting.