Overview

Tax-loss harvesting is a deliberate, rules-based way to use realized investment losses to reduce taxes on capital gains and, in limited amounts, ordinary income. Executed correctly, it can improve after-tax returns without changing a portfolio’s long-term risk profile. This entry explains the tax mechanics, important IRS rules (including the wash-sale rule), reporting requirements, practical workflows, mistakes to avoid, and when the strategy is most and least appropriate for an investor.

How tax-loss harvesting works (step-by-step)

  1. Identify taxable losses: Review tax lots in your taxable brokerage account for positions that have unrealized losses relative to their cost basis.
  2. Realize the loss: Sell the losing position to lock in a capital loss during the tax year.
  3. Offset gains or income: Use realized losses to offset realized capital gains for the year. If losses exceed gains, up to $3,000 ($1,500 if married filing separately) can offset ordinary income; any remaining unused losses carry forward to future years (IRS guidance).
  4. Maintain market exposure: Immediately or soon after a harvest, reestablish similar market exposure with a different, not “substantially identical,” security to avoid losing intended asset allocation.
  5. Report the trades: Report sales on Form 8949 and summarize on Schedule D when filing federal taxes (see IRS instructions).

This netting process reduces taxable income now and defers tax payments, which is often nearly as valuable as permanently reducing tax if the deferred tax is paid later at a similar or lower rate.

Tax rules you must know

  • Netting short- and long-term results: The IRS requires that short-term gains and losses (assets held one year or less) be netted separately from long-term gains and losses (assets held more than one year). The net short-term and net long-term results are then netted against each other to determine overall taxable gain or loss for the year (IRS Topic: Capital Gains and Losses; Publication 550).
  • $3,000 annual offset: If total losses exceed total gains, up to $3,000 of loss ($1,500 MFS) can be deducted against ordinary income each year. Excess losses carry forward indefinitely until used (IRS Publication 550).
  • Wash-sale rule: The wash-sale rule disallows a loss deduction if you buy “substantially identical” stock or securities within 30 days before or after the sale (a 61-day window total). This includes purchases in IRAs and accounts you control; be careful when re-establishing exposure (IRC rules summarized in IRS Publication 550).
  • Reporting: Use Form 8949 to report each sale and Schedule D to summarize capital gain/loss activity. Brokers will issue Form 1099-B that helps complete these forms (IRS: How to Report Capital Gains and Losses).

Sources: IRS Publication 550 (Investment Income and Expenses); IRS Topic “Capital Gains and Losses” and Form 8949 instructions (irs.gov). For consumer-focused guidance, see CFPB materials on taxes and investment accounts.

Practical examples and math

Example A — Offsetting gains:

  • Sold Stock X for a $10,000 long-term capital gain.
  • Sold Stock Y at a $4,000 realized loss.
    Net long-term gain = $6,000. The taxable gain is reduced by the $4,000 loss, lowering tax owed on that gain.

Example B — Using excess losses against ordinary income:

  • Total realized losses for the year: $8,000.
  • Total realized gains for the year: $2,000.
    Net loss = $6,000. First use $2,000 to offset gains; the remaining $4,000 can offset ordinary income up to $3,000 this year and carry forward $1,000.

Tax benefit depends on which rate the loss offsets. If a loss offsets long-term capital gains taxed at 15%, the immediate tax reduction equals 15% of the loss amount offset. If loss reduces ordinary income, the benefit equals the taxpayer’s marginal income tax rate. For high-income earners, long-term gains may be taxed at 20% (plus the 3.8% NIIT in some cases), so the tax benefit changes with the taxpayer’s situation. Always check current capital gains brackets on IRS.gov.

When tax-loss harvesting helps most

  • Taxable brokerage accounts: Losses in tax-advantaged accounts (Roth IRA, traditional IRA, 401(k)) are not deductible and cannot be used for harvesting.
  • Years with realized gains: Investors with large capital gains—due to selling a business stake, concentrated stock sales, or rebalancing—benefit most by offsetting those gains.
  • High-turnover or active portfolios: Frequent traders who incur short-term gains (taxed at ordinary rates) can especially gain from systematically harvesting offsetting losses.
  • Investors who can reestablish exposure thoughtfully: You should be able to replace sold positions with similar but not “substantially identical” securities to stay invested without triggering wash sales.

When to avoid or be cautious

  • Long-term conviction positions: Avoid harvesting losses on holdings you expect to recover and that you want to retain for long-term growth—selling solely for a tax benefit can harm long-term returns.
  • Small-loss trading costs: Transaction costs, bid-ask spreads, and potential tracking error when swapping into similar ETFs can negate tax savings, especially for modest losses.
  • Complex wash-sale exposure: If you maintain similar exposure across multiple accounts or use options, bookkeeping complexity and unintended wash sales may make harvesting costly or risky.

Practical workflow and best practices (professional tips)

  • Calendar and lot tracking: Maintain detailed tax-lot records and calendar reminders for the wash-sale window. Brokers and tax software can help but verify entries manually when active trading occurs.
  • Tax-aware rebalancing: Coordinate harvesting with planned rebalancing to limit turnover and transaction costs.
  • Use tax swaps: Replace a sold security with a different ETF or mutual fund that provides similar exposure but is not substantially identical—for example, swap an S&P 500 ETF A for ETF B from a different provider.
  • Beware of IRAs and related accounts: Buying the same or substantially identical security in an IRA within the wash-sale window still disallows the loss. Keep a 30-day buffer across account types.
  • Year-round approach: Harvest losses throughout the year as opportunities arise rather than only at year-end; this smooths tax outcomes and reduces trading concentrated at year-end.

For more step-by-step workflows and constraints see the site’s practical guides such as Tax-Loss Harvesting: A Practical Guide and timing-focused pieces like Harvesting Tax Losses: Timing and Practical Constraints. For strategy comparisons and when to harvest, see Tax-Loss Harvesting: When and How to Use It.

Common mistakes to avoid

  • Triggering a wash sale by repurchasing substantially identical securities within 30 days.
  • Treating tax savings as guaranteed profit without considering transaction costs or tracking error.
  • Ignoring the long-term capital allocation impact: selling losers can change portfolio risk unless replaced correctly.
  • Failing to report trades accurately: rely on brokers’ 1099-B but verify cost basis information and note discrepancies on Form 8949.

Real-world considerations from practice

In my practice, clients who treat tax-loss harvesting as part of an overall tax-aware investment plan—not a knee-jerk year-end activity—see the best results. One client realized losses methodically over a volatile six-month period, avoided wash sales by using alternate ETFs, and reduced a large capital gains bill while staying fully invested. The administrative burden is modest when tax-lot tracking and trade rules are documented and automated.

Recordkeeping and reporting

Keep trade confirmations and brokerage statements for at least three years (longer if carrying forward losses is likely). Report each sale on Form 8949 with the appropriate adjustment code when the wash-sale rule applies or when cost basis reporting is adjusted, and summarize totals on Schedule D. Consult IRS instructions for Form 8949 and Schedule D for current details (irs.gov).

Sources and further reading

For more FinHelp articles on tactical harvesting and practical workflows, see:

Professional disclaimer

This article is educational and does not constitute tax, legal or investment advice. Tax outcomes depend on your individual facts and current law. Consult a qualified tax professional or financial advisor before implementing tax-loss harvesting strategies in your account.