Tax-loss harvesting is a tax strategy used by investors to minimize taxes on capital gains by intentionally selling investments that have declined in value. By realizing these losses, investors can offset gains from other investments sold at a profit, potentially lowering their tax liability. This method is particularly useful in taxable brokerage accounts since tax-advantaged accounts like IRAs and Roth IRAs do not tax capital gains annually.
How Tax-Loss Harvesting Works
Suppose you purchased 100 shares of a stock for $50 each, totaling $5,000. If the stock price drops to $35 per share, the value falls to $3,500, creating an unrealized loss of $1,500. Selling the stock locks in this $1,500 loss, which can then offset gains realized on other securities you sold for a profit during the same tax year.
Steps for effective tax-loss harvesting include:
- Identify securities in your taxable portfolio currently valued below your purchase price.
- Sell these investments to realize the loss.
- Offset gains realized from other sales to reduce your taxable capital gains.
- Utilize up to $3,000 of excess loss to reduce ordinary income annually, with any remaining losses carried forward to future years.
- Reinvest proceeds in similar, but not “substantially identical,” investments to maintain market exposure while avoiding IRS penalties.
Important: The Wash-Sale Rule
The IRS wash-sale rule disallows claiming a loss if you purchase the same or a substantially identical security within 30 days before or after the sale that produced the loss. To comply, investors must wait at least 31 days before repurchasing the same security or choose a different but similar investment to maintain market exposure without triggering the rule. For more details, see our guide on the Wash-Sale Rule.
Who Benefits from Tax-Loss Harvesting?
This strategy is most advantageous for investors with taxable brokerage accounts who:
- Realize capital gains during the year.
- Regularly rebalance or trade investments.
- Want to manage taxable income efficiently.
- Have long-term investment horizons and consider tax implications as part of their planning.
Investors relying solely on retirement accounts like IRAs won’t benefit, as those accounts don’t tax capital gains annually.
Practical Example
Imagine you earned $5,000 from selling a profitable stock. You also have another stock currently valued $4,000 below the original purchase price. Selling the losing stock realizes a $4,000 loss, which offsets most of the $5,000 gain, making your net capital gain $1,000. This reduction could save you hundreds or thousands depending on your tax bracket.
Tax-Loss Harvesting for Cryptocurrency
Since the IRS treats cryptocurrency as property, losses from crypto sales can offset gains similarly. However, the wash-sale rule currently doesn’t apply to cryptocurrency, though future regulatory changes could affect this. For filing, use Form 8949 to report gains and losses correctly.
Tips for Effective Tax-Loss Harvesting
- Review your portfolio regularly throughout the year, not just at year-end.
- Avoid triggering the wash-sale rule by spacing repurchases accordingly.
- Reinvest in similar but not identical investments to maintain asset allocation without jeopardizing tax benefits.
- Keep thorough records of transactions for accurate tax reporting.
- Remember, tax considerations should not override your overall investment strategy.
Common Mistakes to Avoid
- Confusing tax losses with actual cash gains—harvesting losses reduces taxes but doesn’t generate profit.
- Ignoring wash-sale rules could result in disallowed losses.
- Over-trading solely for tax benefits can increase costs and reduce portfolio growth.
- Sacrificing long-term investment goals for short-term tax gains.
Summary Table
| Feature | Details |
|---|---|
| Purpose | Offset capital gains and reduce taxable income |
| Eligible Accounts | Taxable brokerage accounts (excludes IRAs/Roth IRAs) |
| Maximum Ordinary Income Offset | $3,000 per year |
| Key IRS Rule | Wash-sale rule (avoid repurchasing same security within 30 days) |
| Ideal For | Investors with realized capital gains in taxable accounts |
| Limitations | Doesn’t eliminate taxes completely or guarantee profits |
For further information, explore IRS Publication 550: Investment Income and Expenses and see more on Capital Gains Tax.
Tax-loss harvesting is a valuable tool for managing investment taxes when used thoughtfully within a comprehensive financial plan. It can help you keep more of your investment returns working for you over time.