Tax loss harvesting is one of the most powerful legal strategies for reducing your investment taxes. By strategically selling investments at a loss, you can offset capital gains and even reduce your ordinary income tax. This guide explains how to implement tax loss harvesting effectively while avoiding common pitfalls.
Disclaimer
This is general information, not tax advice. Consult a qualified tax professional for your specific situation.
What Is Tax Loss Harvesting?
Tax loss harvesting is the practice of selling investments that have declined in value to realize a capital loss for tax purposes. These realized losses can then offset capital gains from other investments, reducing your overall tax liability.
The key insight is that paper losses (unrealized) provide no tax benefit. Only when you sell and realize the loss can you use it to offset gains.
Key insight: Tax loss harvesting does not eliminate taxes permanently in all cases. It often defers taxes to future years. However, the time value of money means paying less tax now is valuable, and you may be in a lower tax bracket in the future.
How Tax Loss Harvesting Works
Here is the basic process:
- Identify losing positions: Find investments in your portfolio that have declined below your cost basis
- Sell to realize the loss: Execute a sale to convert the paper loss into a realized loss
- Offset gains: Use the realized loss to offset capital gains from other sales
- Optionally reinvest: Purchase a similar (but not identical) investment to maintain your market exposure
Tax Benefits of Harvesting Losses
Offsetting Capital Gains
Realized losses offset capital gains dollar for dollar. The netting process works as follows:
- Short-term losses first offset short-term gains
- Long-term losses first offset long-term gains
- Net losses in one category offset net gains in the other
Offsetting Ordinary Income
If your capital losses exceed your capital gains, you can deduct up to $3,000 per year ($1,500 if married filing separately) against ordinary income. This provides tax savings at your marginal income tax rate.
Carrying Forward Losses
Unused capital losses carry forward indefinitely until fully used. This creates a valuable tax asset for future years.
Example Tax Savings
Consider a trader in the 32% income tax bracket with the 15% long-term capital gains rate:
- Long-term gains realized: $30,000
- Short-term losses harvested: $20,000
- Net long-term gain: $10,000 (taxed at 15% = $1,500)
- Tax without harvesting: $30,000 x 15% = $4,500
- Tax savings: $3,000
The Wash Sale Rule
The biggest constraint on tax loss harvesting is the wash sale rule. You cannot claim a loss if you buy a "substantially identical" security within 30 days before or after the sale.
What Triggers a Wash Sale
- Buying the same stock within the 61-day window
- Buying options on the same stock
- Purchasing in any account, including IRAs
- Your spouse purchasing the same security
Avoiding Wash Sales While Staying Invested
You can maintain market exposure while avoiding wash sales by purchasing similar but not identical investments:
- Sell individual stock, buy a sector ETF
- Sell one S&P 500 ETF (SPY), buy another (IVV or VOO)
- Sell one tech stock, buy a different tech stock
- Wait 31 days, then repurchase the original security
Key insight: The wash sale rule applies across all your accounts, including IRAs. If you sell a stock at a loss in your taxable account and buy it in your IRA within 30 days, the loss is permanently disallowed - you cannot add it to your IRA cost basis.
When to Harvest Losses
Year-End Harvesting
The most common approach is to review your portfolio in November or December and harvest losses before year-end. This ensures losses offset gains in the current tax year.
Throughout the Year
Sophisticated investors harvest losses whenever significant opportunities arise, not just at year-end. Market downturns present excellent harvesting opportunities.
After Large Gains
If you realize a large gain, immediately look for losses to harvest. This is especially valuable for short-term gains, which are taxed at higher ordinary income rates.
Step-by-Step Harvesting Strategy
Step 1: Calculate Your Current Tax Situation
- Total realized short-term gains for the year
- Total realized long-term gains for the year
- Loss carryforwards from previous years
Step 2: Identify Harvesting Candidates
- Positions with unrealized losses
- Consider both short-term and long-term losers
- Calculate the potential tax savings from each
Step 3: Prioritize Your Harvests
Generally prioritize in this order:
- Short-term losses to offset short-term gains (highest tax rates)
- Long-term losses to offset long-term gains
- Any losses to offset ordinary income (up to $3,000)
Step 4: Execute and Reinvest
- Sell the losing position
- Immediately purchase a similar (not identical) investment
- Document the transactions for tax purposes
Step 5: Track the Wash Sale Window
- Mark your calendar for 31 days after the sale
- Do not buy back the identical security until then
- After 31 days, you can repurchase if desired
Advanced Harvesting Strategies
Harvesting Gains at 0%
If your income is low enough to qualify for the 0% long-term capital gains rate, you can "harvest" gains instead of losses. Sell winning positions, pay no tax, and repurchase immediately at the higher cost basis.
Pairing Gains and Losses
Strategically pair sales to optimize your tax situation. If you need to sell a big winner, look for losses to harvest simultaneously.
Asset Location Considerations
Keep investments likely to generate losses in taxable accounts where you can harvest them. Tax-advantaged accounts like IRAs do not benefit from loss harvesting.
Identify Harvesting Opportunities
Pro Trader Dashboard shows your unrealized gains and losses across all positions, making it easy to identify tax loss harvesting candidates.
Common Mistakes to Avoid
Triggering Wash Sales
The most common mistake is accidentally triggering a wash sale by repurchasing too soon. Be especially careful with automatic dividend reinvestment, which can trigger wash sales.
Harvesting in IRAs
Losses in IRAs provide no tax benefit because IRAs are tax-deferred. Do not sell at a loss in an IRA thinking you will get a deduction.
Ignoring Transaction Costs
Ensure the tax savings exceed your transaction costs. With commission-free trading this is less of an issue, but bid-ask spreads can still add up.
Over-Harvesting
Do not harvest more losses than you can use. While losses carry forward, there is no benefit to harvesting $100,000 in losses if you will never have gains to offset them.
Forgetting State Taxes
Remember that loss harvesting also reduces state income taxes in most states, making it even more valuable.
Record Keeping Requirements
Maintain detailed records for tax loss harvesting:
- Purchase dates and prices for all lots
- Sale dates and proceeds
- Wash sale tracking across all accounts
- Replacement purchases and their dates
- Loss carryforward amounts from previous years
Summary
Tax loss harvesting is a powerful strategy that can save thousands in taxes annually. The key principles are: realized losses offset capital gains dollar for dollar, up to $3,000 in excess losses can offset ordinary income, unused losses carry forward indefinitely, and you must avoid wash sales to claim your losses.
Implement harvesting systematically throughout the year, not just in December. Maintain market exposure by purchasing similar investments, and keep detailed records for tax reporting. When done correctly, tax loss harvesting is one of the few guaranteed ways to improve your after-tax investment returns.
Learn more: understanding wash sales and capital gains tax guide.