How tax-loss harvesting works

Tax-loss harvesting means intentionally selling a security that has lost value to create a realized capital loss on your tax return. That realized loss can offset realized capital gains you’ve already taken during the year. If losses exceed gains, you can use up to $3,000 of net capital losses ($1,500 if married filing separately) to reduce ordinary income in a tax year; any unused losses carry forward indefinitely to future years. (IRS Topic No. 409; see Schedule D and Form 8949 instructions.)

In practical terms: sell the losing lot, record the loss on Form 8949 and Schedule D, then either wait the required period or buy a replacement that won’t trigger the wash‑sale rule (more below). Brokers commonly help by flagging lots and providing tax‑loss reports, but you’re ultimately responsible for correct reporting.

Source: IRS, Topic No. 409 – Capital Gains and Losses; Form 8949 and Schedule D instructions.

Step-by-step example

  1. You bought 100 shares of Fund A for $10,000. Today they’re worth $4,000 (unrealized loss $6,000).
  2. Earlier in the year you sold other holdings and realized $5,000 of capital gains.
  3. You sell Fund A, realizing a $6,000 loss. That loss offsets the $5,000 gain, leaving a $1,000 net capital loss.
  4. That $1,000 can offset up to $3,000 of ordinary income this year; since it’s only $1,000, carryover isn’t needed. If the loss were larger than the allowed ordinary‑income offset, the remainder carries forward.

This simple math shows why harvesting matters: it reduces current taxable gains and can lower taxable income today.

When tax‑loss harvesting makes sense

  • You have realized capital gains this year you want to offset (sales of appreciated stock, mutual funds, or cryptocurrency gains that you’ll report).
  • You expect to remain invested but want to improve after‑tax returns. Harvesting can be a tax timing tool while maintaining market exposure.
  • You expect higher future tax rates or plan to realize gains in future years—capturing losses now can be valuable.
  • You regularly rebalance and can fold harvesting into your rebalancing workflow (but watch for wash‑sale triggers).

When tax‑loss harvesting is usually not worth it:

  • You hold small, short‑term losses where transaction costs, bid/ask spreads, or wash‑sale complications outweigh tax value.
  • The loss comes from tax‑deferred accounts (IRAs, 401(k)s) where selling doesn’t create a deductible loss.
  • You plan to repurchase the exact same security within the wash‑sale window (see below), which will defer—not allow—the deduction.

Key rules and traps to avoid

  • Wash‑sale rule: If you buy the same or a substantially identical security within 30 days before or after the sale, the IRS disallows the loss. That effectively creates a 61‑day window (30 days before sale, day of sale, 30 days after). The disallowed loss isn’t gone forever—it’s added to the cost basis of the replacement shares, deferring benefit. Watch purchases in ALL accounts you control (taxable, IRAs, spouse’s taxable accounts) because wash sales can be triggered across accounts.

    Internal resource: see FinHelp’s wash‑sale explainer for examples and how brokers report them (https://finhelp.io/glossary/wash-sale-rule/).

  • Substantially identical: There’s no bright‑line test for ‘substantially identical.’ Generally, different ETF tickers or broadly diversified index funds are safe swaps; options, single‑stock funds, and very similar mutual funds may be risky.

  • Reporting and forms: Realized losses and gains appear on Form 8949 and flow to Schedule D of Form 1040. Keep detailed records: trade date, lots, cost basis method used (FIFO vs specific identification).

    Source: IRS Form 8949 and Schedule D instructions.

  • Cross‑account and dividend reinvestment risks: Automatic dividend reinvestment or purchases in retirement accounts within the window can create unintended wash sales.

  • Cryptocurrency nuance: As of 2025, the IRS treats most cryptocurrencies as property. The traditional wash‑sale rule applies to stocks and securities; the IRS has not issued explicit guidance applying the wash‑sale rule to crypto. However, tax professionals caution that future guidance could change treatment—monitor IRS notices and your broker’s reporting practices (IRS virtual currency FAQ).

    Source: IRS virtual currency guidance and current FAQs.

Practical strategies and alternatives

  • Use similar but not substantially identical replacements. Swap a sector ETF for a different ETF that tracks a distinct index with similar exposure (for example, replace one S&P 500 ETF with another ETF that tracks a total‑market index but confirm they’re not treated as ‘substantially identical’).

  • Use tax‑lot accounting and specific identification. Selling targeted high‑basis lots first can minimize realized gains; selling low‑basis lots first maximizes loss harvesting. In my practice, specific ID is one of the most underused tactical tools—direct your broker to use it when executing trades.

  • Year‑round harvesting. Waiting until year‑end is common, but harvesting opportunistically during market dips can preserve losses you might otherwise lose if positions rebound.

  • Bracket harvesting: If you expect a low‑income year (sabbatical, retirement transition), consider harvesting gains in those low‑bracket years or saving losses to offset gains in high‑bracket years.

  • Combine with rebalancing. Make harvesting part of your rebalancing rules but prioritize tax lots so you don’t trigger unwanted short‑term gains.

  • ETFs vs mutual funds: ETFs tend to be more tax efficient because of in‑kind creations/redemptions, making them useful replacements or harvesting targets. See FinHelp’s piece on tax‑efficient ETFs for more context (https://finhelp.io/glossary/tax-efficient-use-of-etfs-vs-mutual-funds-in-mixed-accounts/).

How to implement stepwise (checklist)

  1. Review realized gains and projected income for the year.
  2. Run a tax‑lot report to identify losing lots by amount and holding period (short‑term vs long‑term).
  3. Decide whether to harvest short‑term or long‑term losses first (long‑term losses offset long‑term gains; but netting rules apply at year end).
  4. Identify replacement securities that won’t trigger the wash‑sale rule.
  5. Execute sales and purchases, documenting trade dates and lots.
  6. Confirm no automatic purchases (DRIPs) or linked accounts will create wash sales.
  7. Report sales on Form 8949 and Schedule D; carry forward unused losses.

Reporting example and tax math

  • Realized gains this year: $12,000 (mix of short and long‑term)
  • Realized losses harvested: $15,000
  • Net capital loss: $3,000

Result: You use $3,000 to reduce ordinary income this year (limit). If losses had been $20,000, only $3,000 would reduce ordinary income this year and $17,000 would carry forward to offset future gains or $3,000 per year of ordinary income.

Real‑world cautions from practice

In my 15+ years advising clients, two recurring mistakes create the biggest tax headaches:

  1. Ignoring the wash‑sale across accounts. Clients who repurchase in an IRA or in a spouse’s account often have their loss disallowed. Always check all holdings and account automatic settings.

  2. Prioritizing tax savings over investment logic. Harvesting should not create concentration risk or violate your core allocation. Use replacements that preserve your intended exposure.

For more tactical best practices, see FinHelp’s guide on tax‑loss harvesting best practices (https://finhelp.io/glossary/tax-loss-harvesting-best-practices-for-tax-aware-investors/).

Frequently asked questions (short)

Q: Can I harvest losses in retirement accounts?
A: No. Selling inside an IRA or 401(k) generally doesn’t create a deductible loss; losses in tax‑deferred accounts aren’t deductible.

Q: Does tax‑loss harvesting work for crypto?
A: Crypto is treated as property by the IRS. The wash‑sale rule has historically applied to stocks and securities; guidance on crypto is limited. Many advisors treat crypto losses like other property losses but recommend caution and current‑policy checks.

Q: How often should I harvest?
A: At minimum annually; many investors and advisors run a year‑round process to capture losses when volatility creates opportunities.

Final notes and professional disclaimer

Tax‑loss harvesting is a practical and sometimes powerful tax management tool when used within sound investment strategy and careful attention to the wash‑sale rule. It is not a substitute for an investment policy or for advice tailored to your specific tax situation. This article is educational only. Consult a qualified tax advisor or CPA before implementing complex harvesting strategies, especially if you have multiple accounts, complex investments, or potential alternative minimum tax or Net Investment Income Tax considerations.

Authoritative sources: IRS Topic No. 409 (Capital Gains and Losses); Form 8949 and Schedule D instructions; IRS guidance on virtual currency. For related reading on timing gains and year‑end planning, see our Year‑End Tax Checklist (https://finhelp.io/glossary/year-end-tax-checklist-for-individuals/) and FinHelp’s guide on capital gains planning.