What is tax-loss harvesting?

In a nutshell:

Tax-loss harvesting involves selling investments at a loss and then using these losses to offset capital gains on other investments or other income.

• Tax-loss harvesting is only applicable to taxable investment accounts.
• It’s important not to violate the wash sale rule when using tax-loss harvesting.
• Tax-loss harvesting can be particularly effective when used in conjunction with portfolio rebalancing.

How tax-loss harvesting works

If you sell shares in an individual stock, a mutual fund, an ETF or another type of investment for more than you bought it for, you will have realized a capital gain on those shares. If, on the other hand, you sell the shares for a price that is less than you paid, you will have realized a capital loss.

Tax-loss harvesting involves selling investments that have declined in value to purposefully realize a loss on that investment. That might sound strange, but it can be useful: this loss can be used to offset gains that you’ve made elsewhere, which can help reduce or eliminate your net investment gains for the year.

If you have losses that exceed your capital gains for the year, up to $3,000 in excess losses ($1,500 for those who are married and file separately) can be used to offset other income on your tax return. Any excess losses over that amount can be carried forward to a subsequent tax year. There is no expiration date on using these excess losses.

Long-term capital losses are first offset against long-term capital gains, with short-term losses first offset against short-term capital gains. Any remaining gains and losses are then offset against whatever is left.

Long-term gains and losses are defined as losses where the shares being sold were held for at least one year. Long-term capital gains are taxed at preferential rates compared to ordinary income tax rates.

Examples of tax-loss harvesting

Here are a couple of examples of how tax-loss harvesting might work for an investor. We will use these hypothetical holdings to illustrate a couple of transactions.

Example 1

The investor sells one-half of their position in mutual fund A, resulting in a long-term capital gain of $150,000. If they do nothing else, they would have to pay tax on that.

However, if they also sold their entire position in ETF B and $25,000 of their position in stock C this would add up to a capital loss of $150,000. This would fully offset their realized capital gain on the sale of one-half of their position in mutual fund A, reducing the tax they will pay.

The investor is then free to use the proceeds of all of these sales as they wish. This could include reinvesting the money back into their portfolio. While they are free to buy shares of mutual fund A if they wish, they would be prohibited from purchasing shares of ETF B or stock C right away based on the wash-sale rule which is discussed below.

Example 2

Let’s say the investor sold $125,000 of their position in mutual fund A, $100,000 of their position in ETF B and $45,000 of their position in stock C.

The net result of these sales would be a long-term capital loss of $20,000. We will assume no other realized gains or losses for the year.

The first $125,000 of these realized losses would offset the realized capital gains on the sale of mutual fund A. Of the remaining $20,000 in realized losses, $3,000 could be used to offset other income for the investor for the year. The remaining $17,000 would be carried over to use in a subsequent tax year. Tax-losses never expire.

When should you do tax loss harvesting?

Tax-loss harvesting, like most investment or tax planning strategies, should be looked at in the context of your own personal situation to determine if it is appropriate for you. In general this decision should be driven by whether or not the sales of the investment holdings fit with your investing strategy.

It can often make sense to use tax-loss harvesting during portfolio rebalancing, because shares are often sold as part of the rebalancing process.

Portfolio rebalancing

Portfolio rebalancing is used to maintain your portfolio’s target asset allocation, and it often involves selling some of your investments. When you are determining which investments to sell, it can make sense to realize tax losses (as long as they fit with your rebalancing strategy). These losses can be utilized to offset realized gains elsewhere. Be sure to only buy and sell holdings that fit with your strategy as it is generally a bad idea to execute trades solely for tax purposes.

The wash-sale rule

The wash-sale rule prohibits investors from purchasing shares of an identical or substantially identical security that was sold at a loss and then deducting that loss for tax purposes. There is a 61-day window for the wash-sale rule which includes the 30 days before and after the security was sold at a loss plus the day of the sale.

This restriction extends to all accounts owned by the investor. If a loss was realized in an investor’s taxable brokerage account, and then they bought the same in their IRA, they would violate the wash-sale rule.

For standard shares, the rule is clear enough. For example: If you sold shares of IBM at loss, a purchase of IBM shares within the wash-sale period would negate your ability to use the realized loss for tax purposes.

However, with mutual funds or ETFs the definition of an “identical or substantially identical” security can be a bit vague. If you realize a loss on a mutual fund or ETF, clearly buying shares of the identical fund or ETF with the same ticker symbol would violate the wash-sale rule if done within the prohibited time period. But if you sold the Vanguard S&P 500 ETF (ticker VOO) at a loss and then purchased the SPDR S&P 500 ETF Trust (ticker SPY) within the wash-sale time frame, it is not black and white whether this transaction involves two substantially equal securities.

How much tax-loss harvesting can be done in a year?

There is no limit to the amount of tax losses that can be harvested in a given year. As long as you have sufficient realized gains that the losses can be used to offset, there are no annual limits.

However, there is an annual limit of $3,000 in losses ($1,500 for those filing married and separately) for each tax year. Losses in excess of this $3,000 level can be carried over to a subsequent tax year.

The AP Buyline roundup

Tax-loss harvesting can be a useful tool for managing the tax you pay on your investments. Tax-loss harvesting can also be used to offset realized capital gains in your portfolio during the year. It can be incorporated into your normal portfolio rebalancing efforts during the year, and it will make this essential process more tax effective.

While tax-loss harvesting can be a good tactic to use, it's important to realize that it is only a tool, and investments should generally not be sold simply to realize tax losses. The investment reason to sell a holding should be the driver of this decision and not the opportunity to realize a tax loss.

Frequently asked questions (FAQs)

How much can you claim in tax-loss harvesting?

As long as you have realized capital gains that match the amount of realized capital losses, there are no limits as to the amount of tax-loss harvesting that can be claimed.

There is a yearly limit, though. If the amount of your realized capital losses exceeds the amount of your realized capital gains for the year, you can use up to $3,000 in excess realized capital losses ($1,500 for those who are married filing separately) to offset other income earned during the year. Any excess amount of losses exceeding $3,000 can be carried over for use in a subsequent tax year.

Is there a downside to tax-loss harvesting?

Tax-loss harvesting may not be appropriate in all cases. In fact it can backfire on an investor. As an example, if a stock sold at a loss experiences a sudden, pronounced gain, buying it back in the period that violates the wash-sale rule could put you in tax jeopardy. In a case like this, the tax benefits of the realized loss will probably be negated by the missed return from the stock’s price gain.

Additionally, investors in a relatively low tax bracket will generally not realize as much of a tax benefit from tax-loss harvesting as an investor in a higher tax bracket.

Who benefits from tax-loss harvesting?

Generally, higher income investors will tend to benefit more from tax-loss harvesting than investors in a lower tax bracket. The ability to reduce capital gains or use excess losses to offset other income is worth more to higher income taxpayers since the potential tax savings are generally worth more to them.

All investors can benefit from tax-loss to some extent as long as they use it in conjunction with their overall investing strategy and not as the driver of investment decisions. Also be sure to have a plan for the cash realized from selling an investment at either a gain or a loss.