Tax-Loss Harvesting

By Jessica Dosseh

Tax-loss harvesting is a way to cut your tax bill by selling investments at a loss in order to deduct those losses from your taxes, rebalance your portfolios, and keep more money invested. Deducting those losses can offset some or all of the capital gains tax you might owe on other investments you sold for a profit. Note that Tax-loss harvesting (TLH) does not cancel tax obligations; it only postpones the tax bill.

Turn a negative into a positive.

What is tax-loss harvesting?

Simply put, tax-loss harvesting (TLH) is a strategy designed to deliberately take a capital loss in order to use that loss to offset taxes owed on an investment sold at a profit. It works by selling tradable investments such as security (stocks, bonds, shares in an exchange-traded fund) or even cryptocurrencies at a loss and using those losses to offset some, or possibly all, of the short-term and/or long-term capital gains. Investments in the red can be your ticket to a lower tax bill. TLH is more so about tax deferral than tax cancellation.

Investors who don't have investment gains to minimize can still use the losses to offset the taxes they pay on their ordinary income.

Keep in mind.

Learning the basics and rules governing tax-loss harvesting is important to decide if it's a strategy worth employing.

Some of the most important things to know in order to stay on the right side of the IRS are the wash sales rules, the cost basis calculations, and the difference between short-term and or long-term capital gains.

Wash sales rules.

The tax code prohibits "wash sales," which is the practice of using a capital loss for tax-loss harvesting and then repurchasing the identical security (or the "substantially identical" security) within 60 days of the sale that generated the capital loss (30 days before and 30 days after the sale). The wash-sale rule applies to all trades and tax-deferred accounts. Read more about the wash-sale rules here.

Unfortunately, the IRS wash-sale rule does not clearly define what would make a replacement security "substantially identical" to the one sold to harvest a capital loss. Due to this, it is important to talk to an investment professional to avoid violating the wash-sale rule.

Cost basis calculations.

Good records of every purchase are required in order to come up with the proper cost basis to report to the IRS.

A capital gain or loss is calculated by finding the difference between (the cost basis) —what a taxpayer paid for an investment—and (the sale price) —what they earn when they sell it. For example, as soon as an investor sells stock worth $20,000 for $23,000, they have realized a capital gain of $3,000—and that gain is taxable in the year they sold the stock and took the profit. If they so choose, the investor can then deliberately sell one of their other investments at a loss to offset the gain on their tax return. It is also possible for the investor to also use the remaining capital-loss balance to offset personal income—or even carry the loss over to offset gains in future years if losses exceed gains that year.

Difference between short-term and or long-term capital gains

The IRS classifies short-term gains or losses as assets held for less than a year and long-term gains or losses as assets held for more than a year.

Because of this separation in classification, losses of one category must first be used to offset gains of the same category. Short-term capital losses must first be used to offset short-term capital gains; long-term capital losses must first be used to offset long-term capital gains. After that, the remaining losses can be applied to gains in the other categories.

From a tax-loss harvesting perspective, there are a few things to consider. Usually, short-term capital gains have higher tax rates than long-term capital gains. Short-term capital gains can be taxed up to 37%, depending on the income bracket, while long-term capital gains are taxed at a rate of 15% to 20%, depending on income.

After considering all the aspects of the TLH strategy, use Form 8949 and Schedule D (Form 1040) to report your tax-loss harvesting information.

How tax-loss harvesting works.

It applies only to investments held in taxable accounts, preferably in a higher tax bracket.

The IRS does not tax growth on investments in tax-sheltered accounts such as 401(k)s, 403(b)s, IRAs, or 529s, so there's no reason to try to minimize your gains in those particular accounts. Since the idea behind tax-loss harvesting is to lower your tax bill in the present, it's most beneficial for people who are currently in the higher tax brackets to incur bigger savings.

You have only until Dec. 31.

There is no grace period for tax-loss harvesting, so you need to complete all of your harvests before the end of the calendar year, December 31.

Claims are limited to $1,500 to $3,000 a year.

You're allowed up to $3,000 per year to offset taxable income and $1,500 if you're married, filing separately. The good news is that the higher loss balance can be used on future tax returns. Remaining capital-loss balances can be carried over to offset future capital gains (or income) until it is used up. Thus there is no expiration date on the use of capital losses.

Can all investors benefit from tax-loss harvesting strategies?

Yes, investors can benefit from tax-loss harvesting; nevertheless, advocates and critics agree that tax-loss harvesting is appropriate only for certain taxpayers in certain scenarios.

All that needs to be done in the tax-loss harvesting process is:

1. Sell securities that have lost value.

2. Use the capital loss to offset capital gains on other sales.

3. Replace the exited investments with similar (but not too similar) investments to maintain investment exposure.

Tax-loss harvesting allows investors to lower their current tax bill if executed correctly. Still, it is important to remember that tax-loss harvesting does not eliminate the requirement to pay taxes on capital gains. It only postpones it.