Tax-Loss Harvesting

This article is for informational purposes only and does not constitute tax, legal, or financial advice. Tax‑loss harvesting strategies may not be appropriate for every investor, and tax laws can change or vary based on individual circumstances. Before making any decisions, you should consult with a qualified tax professional, CPA, or financial advisor who can evaluate your specific situation

We’re always told to buy low and sell high, but what if there was a benefit to selling low? With tax-loss harvesting, you can take advantage of losses made in one investment to offset gains earned in another.

In this blog, we explain what to know about tax-loss harvesting, including how it works, the purpose and benefits, an example of tax-loss harvesting, limitations and deadlines, and risks and considerations.

What is tax-loss harvesting?

Tax-loss harvesting is a strategy that involves selling investments at a loss to offset the amount of capital gains tax owed. It’s also known as tax-loss selling.

When an investor sells a security at a profit, the gain is subject to capital gains tax. But if they also sell an asset that has declined in value, that loss can be used to reduce (or even eliminate) the tax owed on those gains. In other words, a loss in one security can be used to offset the gain in another, effectively lowering capital gains tax and improving after-tax returns.

Tax-loss harvesting is most commonly used at the end of the calendar year, when investors review their portfolios and assess how their realized gains and losses might impact their tax bill. But you can use tax-loss harvesting at any point during the year when market volatility creates an opportunity to capture losses.

Purpose and benefits of tax-loss harvesting

Let’s take a look at some of the benefits of using a tax-loss harvesting strategy.

Reducing tax liability

The main purpose of tax-loss harvesting is to offset capital gains realized from selling profitable investments. If your capital losses exceed capital gains for a given year, you can use up to $3,000 of the remaining losses to offset ordinary income ($1,500 if you're married filing separately). Any additional unused losses can be carried forward indefinitely to offset future gains or income.

Improve after-tax returns

Ultimately, the goal is to keep more of your investment earnings. The tax savings you generate through harvesting can be reinvested, allowing your portfolio to compound more over time.

Portfolio rebalancing

The process of tax-loss harvesting also offers a good opportunity to shed unprofitable or underperforming investments and realign your portfolio with current investment strategies and goals.

Take advantage of volatility

Market downturns and corrections are ideal conditions for tax-loss harvesting. Instead of seeing this volatility as a setback, you can use the opportunity to capture losses and turn it into a more positive situation. 

How tax-loss harvesting works

Here’s how the process of tax-loss harvesting works, step by step:

1. Identify an underperforming investment: Look for securities currently valued for less than you paid for them
2. Sell the underperforming investment: In doing so, you realize the loss for tax purposes
3. Use that loss to offset realized capital gains from other investments: Short-term losses (held 12 months or less) can offset short-term gains (which are taxed at higher ordinary income rates), while long-term losses (held for more than a year) offset long-term gains
4. Carry forward any remaining losses: If there are more losses than gains, you can use those excess losses to offset up to $3,000 of your ordinary taxable income and remaining losses are carried over indefinitely
5. Reinvest the proceeds: Use the money to invest in a similar (but not identical) asset to maintain your portfolio’s desired asset allocation 
6. Reduce your tax burden: At tax time, the realized losses reduce your taxable income and may result in a lower tax bill.

The wash-sale rule

The wash-sale rule prevents investors from claiming a tax deduction for a capital loss if they buy the same, or a ‘substantially identical’, security within 30 days before or after selling it at a loss. This is to stop investors from harvesting a loss for tax purposes while still technically holding onto the same investment.

So, you essentially have a 61-day window (30 days before, the day of the sale, and 30 days after) during which time you cannot repurchase the stock if you want the loss to be deductible. 

What happens if you violate the wash-sale rule?

The wash-sale rule is enforced by the Internal Revenue Service (IRS). If you're found to be violating the wash-sale rule, the IRS won't approve your capital loss for tax purposes in the current financial year. In other words, they'll treat the transaction as if the loss never happened.

However, the disallowed loss will be added to the cost basis of the newly purchased 'substantially identical' security. The higher cost basis will reduce the capital gain, or increase the capital loss, if you eventually sell the new position in the future.

Trades that do not meet the definition of a wash sale

 reinvesting the proceeds from a loss into a similar but not substantially identical investment.

One example of this is to use exchange-traded funds (ETFs) that track similar indexes. For example, if a trader sells one S&P 500 ETF at a loss, and purchases another S&P 500 ETF from a different issuer this does not violated the wash-sale rule. Each fund is considered a distinct security.

Other Examples:

• Waiting more than 30 days before you buy back the same security
• Choosing a different stock or fund with similar characteristics
• Don’t claim the capital loss for tax purposes (though this defeats the purpose of tax-loss harvesting).

Note: This is not tax advice and always consult a tax professional before you attempt tax-loss harvesting.

Tax-loss harvesting limits and deadlines

The IRS sets specific rules and limits when it comes to tax-loss harvesting.

The $3,000 annual deduction limit

You can use realized capital losses to offset an unlimited amount of capital gains each year. If you have more capital losses than capital gains, you can apply up to $3,000 of the losses to offset your ordinary income ($1,500 if you’re married filing separately).

If your capital losses exceed that amount, you can carry forward the unused portion to future tax years.

For example, if you have $25,000 in total losses and only $10,000 in capital gains, you could:

• Deduct $10,000 to offset the gain
• Deduct $3,000 against your ordinary income
• Carry forward the remaining $12,000.

There’s no expiration date on capital losses rolling forward, so you can carry them into the future indefinitely.

Year-end deadline

All transactions for tax-loss harvesting must be completed by the end of the tax year, usually December 31. This includes settlement times, so it’s best to execute all harvesting trades well before the final week of December to not miss out.

When to use tax-loss harvesting

Some situations where tax-loss harvesting can be useful include:

• Rebalancing during market fluctuations: Rebalancing your portfolio during an upmarket can trigger taxable gains. Harvesting losses from underperforming positions can help offset those gains.
• Using down markets to convert to Roth accounts: Converting a traditional IRA or 401(k) into a Roth account can result in a lower taxable income during market downturns. To further reduce the tax owed on that conversion, you can perform tax-loss harvesting during the same year.
• Keeping adjusted gross income (AGI) lower: Strategic harvesting can lower your AGI, helping keep you in a lower tax bracket and preserving eligibility for Roth IRA contributions.
• Managing significant or complex portfolios: High-net-worth investors with gains across businesses, properties, and multiple asset classes often use tax-loss harvesting to neutralize large gains and maintain tax efficiency.
• Preparing for retirement: Investors nearing retirement often hold large positions in company stock or low-basis investments. In these situations, combining tax-loss harvesting with net unrealized appreciation (NUA) planning can reduce tax distributions and create a more tax-efficient retirement withdrawal plan.

Risks and considerations in tax-loss harvesting

There are a few things to consider before you start tax-loss harvesting:

• Trading costs: Every time you sell one security and buy another, you might be incurring bid-ask spreads or brokerage commissions. These costs can sometimes outweigh the expected tax benefits.
• Wash-sale rule: This IRS rule prevents you from selling a security at a loss and then buying the same security, or a ‘substantially identical’ one, within 30 days before or after the sale. If you violate this rule, the loss will be disallowed for tax purposes, though it will be added to the cost basis of the repurchased security.
• Retirement accounts don’t qualify: Tax-loss harvesting only applies to taxable accounts. You can’t use losses realized inside traditional IRAs, Roth IRAs, 401(k)s, or other tax-deferred accounts to offset capital gains or ordinary income.
• Tax lot identification: If you bought shares of the same security at different times and prices, you must identify which tax lot you’re selling. This affects the size of the realized loss (or gain) and the accuracy of your tax reporting.
• Limited benefits for lower-income investors: Investors in the 0% long-term capital gains tax bracket are unlikely to benefit from harvesting losses against long-term gains already taxed at zero.
• Potential market timing errors: Selling an investment too early might cause you to miss a potential rebound. You should never use tax-loss harvesting to override a long-term investment strategy or asset allocation goals.
• Reinvestment challenges: It can be tricky to find an appropriate ‘replacement’ security without breaching the wash-sale rule.