Direct Indexing 101

Filing your taxes: Turning tax losses into real dollar savings

5 min read

With Frec Direct Indexing, you can expect to tax loss harvest up to 45% of your portfolio over 10 years, or 14.7% in the first year.1

14.7% sounds great, but what does that actually mean for you? 

We’ll break it down for you using an average 33.3%2 tax rate and a one-time $50,000 investment. Assuming 14.7% of your portfolio was tax loss harvested in the first year, that is a total of $7,200. However, that doesn’t mean you receive $7,200 back in your pocket. It means you can apply that number as a loss line item on your tax form. As such, you can use that loss for one of two things: 

1. Reduce your capital gains 
2. Deduct from other kinds of income, like your salary or interest income

Let’s break down each of the above situations: 

1. Reducing your short & long-term capital gain taxes

What are long term & short term capital losses and gains?

It’s first important to explain that a capital gain will occur when you sell stock you own at a price that is higher than what you paid for it and a loss will occur when you sell stock you own at a price lower than what you paid for it. Then you can separate these two categories even further into short term and long term. If you hold a stock for longer than a year prior to selling it, it’s considered a long-term capital gain or loss and if it’s less than a year it’s short-term. 

The reason it’s important to know whether your gains are short-term or long-term is because the  IRS taxes them differently. Your short term gains will be taxed as ordinary income, while long-term gains are taxed at the capital-gains tax rate. Capital-gains tax rate can be significantly lower than ordinary income tax. It’s currently 15%3 for those with a 33.3% ordinary income tax rate. You’re then able to use losses to offset these taxes, but you’re required to offset gains of the same type as the losses. However, if your losses of one type are more than the gains of that type, then you can use the difference to offset the other type of gain. Here’s an example:

  1. You had $15,000 in long-term losses
  2. You sold stock A which resulted in $5,000 in long-term gains. You also sold stock B which resulted in $5,000 in short-term gains.
  3. You use $5,000 of the $15,000 in long-term losses to offset your $5,000 in long-term gains. You can also use $5,000 in long-term losses to offset the $5,000 in short-term gains since you don’t have any short-term losses to use. 
  4. This leaves you with $5,000 in long-term losses. You can use this extra to offset $3,000 on your income and carry $2,000 in long-term losses into the next year to use on future capital gains.

What if you didn’t have any short-term gains to offset with the extra $10,000, though?

Not to worry! You can still use $3,000 of the $10,000 to deduct from your ordinary income and carry forward the extra $7,000 to use in future tax years to offset future gains or future income.

2. Reducing your ordinary income by $3,0004

What does it actually look like when you deduct $3,000 from your ordinary income?

Let’s say you didn’t have any dividends last year, but your earned ordinary income was $125,000. You can use the $3,000 to reduce your ordinary income to $122,000. You are then charged your 33.3% interest rate on the $122,000 instead of the $125,000 and you can see the calculations and savings below: 

$125,000 x .333 = $41,625.00

$122,000 x .333 = $40,626.00

Difference = $999.00 

Basically, the $3,000 deduction will allow you to keep about $1,000 in your pocket. It’s money you no longer have to pay to the IRS.

The simple process of filing your tax losses

It’s the New Year and you’ve probably set some goals for the coming year. You’re also probably thinking about the looming tax deadline and making sure you have all your tax documents ready for it. You’ve signed up for Frec’s direct indexing strategy and you’ve been harvesting losses almost daily. You probably have questions similar to these: 

• Does this mean you’ll have to enter in every single transaction? 
How much time is this going to take to file and will it be worth it?

The short answer is no! You do not have to enter in every single trade that got you a tax loss for the year. It shouldn’t increase your filing time any more than it typically takes you or your tax advisor to complete. You only need to enter in a couple of numbers (not hundreds). 

Your Consolidated 1099 Tax Form

At the mid or end of February every year, you’ll receive what is called a 1099 consolidated tax form from Frec. You’ll receive an email from us letting you know it’s available and you’re able to download a pdf of it from the documents tab in the Settings of our platform. There is a summary at the beginning of the form that details out the total short-term or long-term gains or losses. Below is a screenshot example of what your form will look like.

You’ll enter the above number totals into your Schedule D tax form and the total into line 7 of your form 1040 US individual Income Tax Return Form or provide it to your tax adviser to handle or enter it when requested by TurboTax.

The number for 7 is determined by completing Schedule D, which uses the summary of capital gains and losses for long-term and short-term, but it’s not a transaction by transaction filing. See below for an example of Schedule D.

That’s it! Calculating your gains/losses is easy and online tax filing services like TurboTax will easily ingest this information, potentially reducing the taxes you owe.

The article is for informational purposes only. Frec does not provide tax advice and investors are encouraged to consult with their personal tax advisors.

  1. A 45.1% return was generated by Frec’s Direct Indexing Model tracking the S&P 500 index and is hypothetical, does not reflect actual investment results, and is not a guarantee of future results. Simulations were run on a weekly basis in a ten-year time frame from 12/17/2003 - 6/10/2022 with a $50,000 initial deposit. The simulations averaged at the end of year ten resulted in 45.1% accumulated tax savings and the average results at the end of year one were 14.7%.
  2.  Tax rate based on 2023 federal and state combined tax rate for an individual with a salary between $190,751-$364,200. 
  3. 15% is the 2023 capital gains rate for single tax filers making between $44,626-$492,300.
  4. You can deduct up to $3,000 of ordinary income or $1,500 for married individuals filing separately.