Tax-Loss Harvesting Explained

What Is Tax-Loss Harvesting?

Tax-loss harvesting is selling investments at a loss to offset capital gains or reduce taxable income. You're essentially converting investment losses into tax deductions.

How It Works

1. Identify losing positions in your taxable accounts
2. Sell to realize the loss
3. Use the loss to offset gains (or up to $3,000 of ordinary income)
4. Optionally: Buy a similar (but not identical) investment to maintain exposure

The Tax Benefits

Offset Capital Gains

Capital losses first offset capital gains dollar-for-dollar. If you have $10,000 in gains and harvest $10,000 in losses, your net capital gains = $0.

Offset Ordinary Income

If your losses exceed your gains, you can deduct up to $3,000 against ordinary income each year. At a 32% tax bracket, that's $960 saved.

Carry Forward Losses

Unused losses carry forward indefinitely. If you harvest $50,000 in losses this year, you can use them against future gains or $3,000/year against income forever.

The Wash Sale Rule

Here's the catch: you can't claim a loss if you buy "substantially identical" securities within 30 days before or after the sale.

What Triggers a Wash Sale

• Buying the same stock within 30 days (before or after)
• Buying an option on the same stock
• Buying in a different account (including IRA)
• Spouse buying the same security

How to Avoid Wash Sales

• Wait 31 days before buying back
• Buy a similar (not identical) security immediately

Similar But Not Identical

The IRS doesn't define "substantially identical" precisely, but generally:

• Selling SPY → Buying VOO = probably a wash sale (both track S&P 500)
• Selling SPY → Buying VTI = probably OK (total market vs S&P 500)
• Selling Apple → Buying Microsoft = OK (different companies)
• Selling Apple → Buying QQQ = OK (ETF vs individual stock)

Step-by-Step Tax-Loss Harvesting

1. Review your portfolio for positions with unrealized losses
2. Identify offsetting gains you've realized this year
3. Calculate potential tax savings
4. Sell the losing position
5. Immediately buy a similar investment (to stay invested) OR wait 31 days
6. Track the loss for your tax return

When to Harvest

Year-End Review

December is traditional harvest season. Review gains, identify losses to offset them, and execute before year-end.

After Market Drops

Big corrections create harvesting opportunities. March 2020, late 2022—these were prime times to harvest and reset cost basis.

Ongoing Harvesting

Some investors (and robo-advisors) harvest year-round whenever losses exceed a threshold.

Important Limitations

Only Taxable Accounts

Tax-loss harvesting only works in taxable brokerage accounts. IRAs and 401(k)s don't have capital gains taxes, so there's nothing to harvest.

Transaction Costs

With $0 commissions now common, this is rarely an issue. But consider bid-ask spreads on less liquid securities.

Don't Let Tax Tail Wag Investment Dog

Tax savings shouldn't override investment decisions. Don't sell a great long-term holding just to harvest a loss.

The Bottom Line

Tax-loss harvesting is free money if you have losing positions and taxable gains. The mechanics are simple:

• Sell losers to realize losses
• Use losses to offset gains (unlimited) or income ($3,000/year)
• Wait 31 days or buy similar-but-not-identical to stay invested
• Carry forward unused losses forever

In a bad market year, aggressive harvesting can create years of tax benefits. It's one of the few silver linings of down markets.