Tax-loss harvesting is a strategy that involves selling securities at a loss in order to offset capital gains taxes on the sale of other securities. Tax-loss harvesting is applicable to securities held in taxable accounts.
How tax-loss harvesting works
Tax-loss harvesting is a relatively straightforward matter of addition and subtraction, with some IRS rules thrown into the mix. When you sell a security, such as stock in a company or a mutual fund for less than the price you paid for it, you realize a loss. You can then use that loss to offset the capital gains you realize when you sell other securities that have appreciated. This offsetting loss lowers your tax liability. At the end of the year, you will pay capital gains taxes on the net capital gains across all of your short- and long-term security transactions.
From a tax filing perspective, tax loss harvesting happens on Form 1040, Schedule D, where the totals of short- and long-term capital gains on securities you have sold during the year are totaled to figure your capital gains tax.
Maintaining portfolio positions
Many investors target a specific mix of securities based on their risk tolerance and investing goals. For example, an investor or their financial advisor may want to keep a stock portfolio balanced between stocks in five sectors (like utilities, healthcare, consumer goods, energy and tech). If one of those stocks gains disproportionately, the investor might want to take a profit by selling that stock and invest the proceeds in other securities in other sectors.
To offset that capital gain, the investor can sell any stocks that have lost value since they were purchased. This option is especially useful in years when the markets have experienced a lot of volatility.
Avoid the “wash-sale” rule
Investors who buy and sell the same stock within 60 days should be careful to not run afoul of the “wash-sale” rule, however. The wash-sale rule is an Internal Revenue Service regulation to prevent investors from artificially lowering their investments’ cost bases. If you sell a security for a loss and purchase a “substantially similar” security 30 days before or after the sale, the tax loss cannot be claimed.
For example, selling 1,000 shares of a company’s stock three weeks after you purchased shares in the same company would create a wash sale. You may sell a stock because its share price fell on bad news, and then hear good news that makes you want to buy it back. You can buy it back within 30 days of your original sale, but you can’t claim a capital loss on your taxes.
Some investors may employ a strategy such as purchasing an industry-tracking ETF to offset a sale of an individual company’s stock if they want to maintain a portfolio position without triggering a wash-sale.
Example of tax-loss harvesting
So, what does tax-loss harvesting look like? Here’s an example.
Let’s suppose your portfolio consists of the following securities in a taxable account:
- A $50,000 position in Mutual Fund A with a long-term unrealized gains of $10,000
- A $30,000 position in Mutual Fund B with a long-term unrealized loss of $5,000
- A $40,000 position in Mutual Fund C with a long term unrealized loss of $7,000
If you sold your position in Mutual Fund A, you would owe long-term capital gains tax on the $10,000 gain. The specific rate that you owe would be based on your tax filing status and income. In 2022, if you earn $459,751 or more, you are subject to a 20% tax rate on long term capital gains, so let’s just assume that you are subject to a 20% tax rate on long-term capital gains. Here’s how the math works out:
$10,000 (long-term capital gain on Mutual Fund A) * 20%
\= $2,000 tax liability.
However, if you sold Mutual Fund B at a loss, you could use the $5,000 long-term loss on this security to partially offset the loss from Mutual Fund A.
$10,000 (long-term capital gain on Mutual Fund A) * 20%
- $5,000 (long-term capital loss on Mutual Fund B) * 20%
\= $1,000 tax liability.
Further if you wanted to offset your entire capital gain, you could also sell Mutual Fund C.
$10,000 (long-term capital gain on Mutual Fund A) * 20%
- $5,000 (long-term capital loss on Mutual Fund B) * 20%
- $7,000 (long-term capital loss on Mutual Fund C) * 20%
\= -$400 tax liability.
In this case, you would have completely offset all of the capital gains from Mutual Fund A and have an additional amount that you can use to offset ordinary income from other sources.
When should you do tax loss harvesting?
Tax loss harvesting is a strategy that you can use any time you sell securities at a gain and hold other securities that you can sell at a loss. If you can purchase alternate securities with the proceeds from your loss sale that maintain your desired portfolio position, you have found a good opportunity to take advantage of tax loss harvesting.
Conversely, whenever you are selling securities at a loss, you should consider realizing gains from some securities in order to offset the capital loss, lest you miss out on the opportunity to lower your capital gains taxes.
Timing your trading
If you want to take advantage of tax loss harvesting, you need to make sure that your gains and losses are realized in the same tax year. You can only use capital gains and losses realized in the same year to offset each other, with the exception that you can carry long-term capital losses forward to future tax years. Many investors wait until the end of the year to make strategic trades and take advantage of tax-loss harvesting. But don’t wait too long. You can’t make trades after the last day of the year and use them for the previous tax year.
The second consideration to timing your trading applies to short term and long-term capital gains and losses. If you have a security that you’ve held for almost a year and want to use its short-term loss to offset a short-term capital gain, you should be sure to sell it before you have held the security long enough for it to become a long-term capital gain.
Tax-loss harvesting limits
There is generally no limit on the amount of tax losses you can harvest in a year. The IRS does limit the amount of excess losses you can use to offset your ordinary income, and there are rules regarding short-term and long-term capital gains and losses.
A single taxpayer can use up to $3,000 in capital losses to offset ordinary income. This limit drops to $1,500 for taxpayers who are married, but filing separately. For example, if you realize a long-term capital gain of $3,000 on the sale of one security and take a $3,000 long-term loss on the sale of another security, you must use the capital loss to offset the capital gain before any remaining amount can be used to offset ordinary income.
It’s also important to note that short-term and long-term net capital gains and losses are tallied separately. Short-term losses can only be used to offset short-term capital gains and long-term losses can only be used to offset long-term gains. Excess short-term capital gains must be used in the same tax year, but long-term capital losses can be carried forward to future tax years.
Finally, tax-loss harvesting is only applicable to securities held in taxable accounts. You cannot do tax loss harvesting in your 401k, Roth IRA, or other retirement account. You should, however, watch out for trades within these accounts that could create a wash sale.
Tax loss harvesting is a strategy that you can employ in your taxable investment accounts to reduce the amount of short- and long-term capital gains taxes you pay when you sell securities and realize both gains and losses in the same tax year. In addition to offsetting your capital gains, you can use up to $3,000 of capital losses to offset your ordinary income and you can carry over long-term capital losses to future tax years.