Tax Loss Harvesting, Explained

March 18, 2024

Tax Loss Harvesting, Explained 


What is tax loss harvesting, exactly? If you’ve heard the term but aren’t sure what it means or whether it has any relevance for your investment portfolio, stick with us. In the following guide, we provide a brief definition of tax loss harvesting, including how it works and why investors use it. 

What is tax loss harvesting? 

Tax loss harvesting is a tax strategy that involves selling investments at a loss in order to offset or reduce the capital gains tax liability incurred from selling other investments at a profit. Investors use tax loss harvesting to reduce their annual tax bill. Tax loss harvesting can be an effective strategy for deferring taxes and maintaining a balanced investment portfolio, but it must be done properly to avoid penalties by the IRS. 

Let’s take a look at how tax loss harvesting works. 

How does tax loss harvesting work? 

Investors typically turn to tax loss harvesting at the end of the tax year after they have assessed the performance of their portfolio and its impact on their annual taxes. An investor will sell one investment with a loss in value in order to offset another investment’s increase in value and the capital gains tax liability incurred. Then he or she will use the proceeds of the sale to purchase a similar asset in order to balance the portfolio—under the strict guidelines of the IRS. 

Tax loss harvesting is a strategy used by investors with taxable investment gains. Since the IRS does not tax the growth of investments in tax-sheltered accounts, you wouldn’t use this strategy with investments in a 401(k), 403(b), IRA, or 529 plan. 

One important thing to understand about tax loss harvesting is that if your annual capital losses are greater than your annual capital gains, then you can deduct up to $3,000 in net losses from your annual ordinary income. If your annual net losses exceed $3,000, then the IRS allows you to carry forward the additional losses into future tax years. 

Another important thing to consider with tax loss harvesting is the importance of maintaining a carefully balanced investment portfolio. When you sell an asset at a loss, the balance of the portfolio gets disrupted. For this reason, investors will try to replace the asset sold with a similar asset to keep the portfolio’s expected levels of risk and return. 

Let’s take a look at several IRS rules and regulations for tax loss harvesting next. 

IRS rules and regulations for tax loss harvesting

The wash-sale rule mandates that investors refrain from purchasing the same stock that was sold at a loss within 30 days before and 30 days after the sale of the asset. If the IRS deems a purchased asset as “substantially identical” to the one sold, the transaction is labeled a “wash-sale” and cannot be used to offset capital gains. If the wash-sale rule is violated repeatedly, investors can be penalized. 

According to IRS rules, losses on your investments are first used to offset capital gains of the same type. In effect, short-term losses will first offset short-term gains (assets held for less than one year) and long-term losses will first offset long-term gains (assets held for more than one year). Afterwards, net losses of either type can be used to offset the other type of capital gains.

Investors who use tax loss harvesting should keep in mind that all of their harvesting efforts must be completed by the end of the calendar year—December 31st. Don’t make the mistake of thinking you have until the tax-filing deadline to make your move. The IRS offers no such leniency with tax loss harvesting activity. 

In addition, investors should also keep in mind that while tax loss harvesting can lower your current tax bill, it does so by deferring taxes to future tax years, not by eliminating them. 

Is tax loss harvesting the right tax strategy for you? 

If you’re wondering whether tax loss harvesting could be the right tax strategy for you, we recommend speaking with a qualified investment tax professional who can help you weigh the pros and cons for your individual situation. 

The tax experts at Honest Buck can help you develop a tax and investment strategy that works for you. 

Contact us today to learn more. 

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