What Is Tax-Loss Harvesting?

What Is Tax-Loss Harvesting?

I'm here to explain tax-loss harvesting directly to you—it's when you sell securities at a loss to offset the capital gains taxes you owe from selling profitable assets. You use this strategy to limit short-term capital gains, which are taxed at a higher rate than long-term ones, so you can preserve your portfolio's value and cut down on taxes.

Key Takeaways

You can use tax-loss harvesting as a strategy to reduce the capital gains taxes from your profitable investments. It involves selling an asset or security at a net loss. Then, you take the proceeds from that sale to buy a similar asset, which helps you keep your portfolio balanced.

How Tax-Loss Harvesting Works

You might know tax-loss harvesting as tax-loss selling. Most investors like you apply this at year-end when reviewing your portfolio's performance and its tax impact. If an investment has lost value, sell it to claim a credit against profits from other assets.

This is a straightforward tool for cutting your overall taxes. Say you have a loss in Security A—you sell it to offset the gain in Security B, wiping out the capital gains tax on B. By doing this, you can achieve real tax savings.

Tip on Excess Losses

If your capital losses exceed your gains for the year, you can deduct up to $3,000 in net losses from your total annual income—or $1,500 if you're married filing separately. If your net losses go beyond that, IRS rules let you carry the extra forward to future tax years.

Maintaining Your Portfolio

When you sell an asset at a loss, it can throw off your portfolio's balance. After harvesting the loss, if you've built your portfolio carefully, replace the sold asset with something similar to keep the asset mix, risk, and expected returns on track. Just don't buy back the exact same asset you sold, as that could trigger the IRS wash-sale rule.

Important Note on Offsetting Losses

Your investment losses first offset capital gains of the same type—short-term losses go against short-term gains, and long-term against long-term. But if you have net losses in one category, you can then deduct them against gains in the other category.

The Wash-Sale Rule

You need to avoid the wash-sale rule, which means not buying the same stock you sold at a loss for tax purposes. A wash sale happens if you sell a security and then buy a substantially identical one within 30 days. If it's deemed a wash sale, you can't use it to offset gains, and abusing this could lead to fines or trading restrictions from regulators.

In your tax-loss harvesting, you can use ETFs that track similar indexes to swap without breaking the rule. For instance, sell one S&P 500 ETF at a loss and buy a different one to claim the loss.

Example of Tax-Loss Harvesting

Let's say you're a single investor with $580,000 income in 2024, facing a 37% marginal tax rate and 20% on long-term capital gains. Short-term gains get taxed at your marginal rate.

Your portfolio shows: Mutual Fund A with $250,000 unrealized gain held 450 days, Mutual Fund B with $130,000 unrealized loss held 635 days, Mutual Fund C with $100,000 unrealized loss held 125 days.

Trading: Sold Mutual Fund E for $200,000 gain held 380 days, Sold Mutual Fund F for $150,000 gain held 150 days.

Without harvesting, taxes are ($200,000 x 20%) + ($150,000 x 37%) = $95,500.

With harvesting by selling B and C: (($200,000 - $130,000) x 20%) + (($150,000 - $100,000) x 37%) = $32,500.

How Does Tax-Loss Harvesting Work?

It works by using capital losses to offset gains—you sell unprofitable investments to reduce taxes on profitable ones sold that year, then buy similar investments to keep your portfolio balanced.

What Is a Substantially Identical Security and How Does It Affect Tax-Loss Harvesting?

You can't break the wash-sale rule by selling at a loss and buying a substantially identical asset within 30 days before or after. That would invalidate your tax loss. A substantially identical security is one from the same company or a derivative on the same security.

How Much Tax-Loss Harvesting Can I Use in a Year?

If losses exceed gains, you can claim up to $3,000 excess loss—or $1,500 if married filing separately—or your total net loss from Schedule D, per IRS. Anything more carries forward to later years.

The Bottom Line

Tax-loss harvesting means selling securities at a loss to offset gains taxes from profitable assets. You can write off up to $3,000 in net losses annually—or $1,500 if filing separately. If you have questions on maximizing tax breaks, consult a professional tax advisor.