What Is Tax-Loss Harvesting?
Tax-loss harvesting is the timely selling of securities at a loss to offset the amount of capital gains tax owed from selling profitable assets.This strategyis commonly used to limit short-term capital gains, commonly taxed at a higher rate than long-term capital gains, to preserve the value of the investor’s portfolio while reducing taxes.
Key Takeaways
- Tax-loss harvesting is a strategy investors can use to reduce capital gains taxes owed from selling profitable investments.
- A tax-loss harvesting strategy involves selling an asset or security at a net loss.
- You can use proceeds from a sale to purchase a similar asset and maintain the portfolio balance.
How Tax-Loss Harvesting Works
Tax-loss harvesting is also known as tax-loss selling. Most investors use this strategy at the end of the year when they assess the annual performance of their portfolios and its impact on their taxes. An investment that shows a loss in value can be sold to claim a creditagainst the profits that were realized in other assets.
Tax-loss harvesting is a tool for reducing overall taxes. A loss in the value of Security A could be sold to offset the increase in the price of Security B, thus eliminating thecapital gainstax liabilityof Security B. Using the tax-loss harvesting strategy, investors can realize significant tax savings.
If your capital losses for the year exceed your capital gains, you can deduct up to $3,000 in net losses from your total annual income. If your net losses exceed $3,000, Internal Revenue Service (IRS) rules allow the additional losses to be carried forward into the following tax years.
Maintaining Your Portfolio
Selling an asset at a loss disrupts the balance of the portfolio. After tax-loss harvesting, investors with carefully constructed portfolios replace the asset sold with a similar asset to maintain theportfolio'sasset mix and expected risk and return levels. You should avoid buying the same asset that you just sold at a loss, which may violate the IRS wash-sale rule.
Losses on your investments are first used to offset capital gains of the same type. Therefore, short-term losses are first used to offset short-term capital gains tax, and long-term losses are first used to offset long-term capital gains tax. But net losses of either type can then be deducted against the other kind of gain.
The Wash-Sale Rule
The wash-sale rule requires that investors avoid buying the same stock sold at a loss for tax purposes. A wash sale involves the sale of one security and, within 30 days, purchasing a substantially identical stock or security. If a transaction is considered a wash-sale, it cannot be used to offset capital gains, and if wash-sale rules are abused, regulators can impose fines or restrict the individual's trading.
Using ETFs that track the same or similar indexes can be used to replace one another while avoiding violating the wash sale rule in a tax-loss harvesting strategy. If you sell one S&P 500 index ETF at a loss, you can buy a different S&P 500 index ETF to harvest the capital loss.
Example of Tax-Loss Harvesting
Assume a single investorearns an income of $580,000 in 2023. The investor's marginal income tax rate is 37% and is subject to the highest long-term capital gains tax category, where gains are taxed at 20%. Short-term capital gains are taxed at the investor's marginal rate.
Below are the investor's portfolio gains and losses and trading activity for the year:
Portfolio:
- Mutual Fund A: $250,000 unrealized gain, held for 450 days
- Mutual Fund B: $130,000 unrealized loss, held for 635 days
- Mutual Fund C: $100,000 unrealized loss, held for 125 days
Trading Activity:
- Mutual Fund E: Sold, realized a gain of $200,000. Fund was held for 380 days
- Mutual Fund F: Sold, realized a gain of $150,000. Fund was held for 150 days
The tax owed from these sales is:
- Tax without harvesting = ($200,000 x 20%) + ($150,000 x 37%) = $40,000 + $55,500 = $95,500
If the investor harvested losses by selling mutual funds B and C, the sales would help to offset the gains, and the tax owed would be:
- Tax with harvesting = (($200,000 - $130,000) x 20%) + (($150,000 - $100,000) x 37%) = $14,000 + $18,500 = $32,500
How Does Tax-Loss Harvesting Work?
Tax-loss harvesting takes advantage of the fact that capital losses can be used to offset capital gains. An investor can "bank" capital losses from unprofitable investments to pay fewer capital gains tax on profitable investments sold during the year. This strategy includes using the proceeds of selling unprofitable investments to buy similar investments that preserve the portfolio's overall balance.
What Is a Substantially Identical Security and How Does It Affect Tax-Loss Harvesting?
The investor cannot violate the IRS' wash sale rule by selling an asset at a loss and buying a substantially identical asset within 30 days before or after that sale. Doing so will invalidate the tax loss write-off. A substantially identical security is defined as a security issued by the same company or a derivative contract issued on the same security.
How Much Tax-Loss Harvesting Can I Use in a Year?
If your capital losses exceeds your capital gains, you can claim excess loss of the lesser of $3,000 ($1,500 if married filing separately) or your total net loss shown on line 16 ofSchedule D (Form 1040), according to the IRS. If have a greater net capital loss that that, you can carry the loss forward to later years.
The Bottom Line
Tax-loss harvesting is the timely selling of securities at a loss to offset the amount of capital gains tax owed from selling profitable assets.An individual taxpayer can write off up to $3,000 in net losses annually. For more advice on how to maximize your tax breaks, consider consulting a professional tax advisor.
FAQs
Tax-loss harvesting is the timely selling of securities at a loss to offset the amount of capital gains tax owed from selling profitable assets. An individual taxpayer can write off up to $3,000 in net losses annually. For more advice on how to maximize your tax breaks, consider consulting a professional tax advisor.
What is a tax-loss harvesting example? ›
Even if you don't have capital gains to offset, tax-loss harvesting could still help you reduce your income tax liability. Let's say Sofia, a single income-tax filer, holds XYZ stock. She originally purchased it for $10,000, but it's now worth only $7,000. She could sell those holdings and take a $3,000 loss.
How much can you write off with tax-loss harvesting? ›
Usually, you can claim up to $3,000 per year (or $1,500 per person if married and filing separately). If you lost more than the $3,000 limit, you can carryover the excess amount to offset capital gains or other income on future tax returns.
Is there a downside to tax-loss harvesting? ›
All investing is subject to risk, including the possible loss of the money you invest. Tax-loss harvesting involves certain risks, including, among others, the risk that the new investment could have higher costs than the original investment and could introduce portfolio tracking error into your accounts.
Why are capital losses limited to $3,000? ›
The $3,000 loss limit is the amount that can be offset against ordinary income. Above $3,000 is where things can get complicated.
How much stock loss can you write off? ›
No capital gains? Your claimed capital losses will come off your taxable income, reducing your tax bill. Your maximum net capital loss in any tax year is $3,000. The IRS limits your net loss to $3,000 (for individuals and married filing jointly) or $1,500 (for married filing separately).
Who benefits most from tax-loss harvesting? ›
Investors who may want to consider tax-loss harvesting include those who plan to donate their portfolio to charity or bequest it to heirs, as this would not involve realizing capital gains. Investors who plan to liquidate their portfolio eventually would then pay taxes on realized gains.
Do you get money back from tax-loss harvesting? ›
Investors using tax-loss harvesting may choose to sell some securities at a loss, then use those losses to offset capital gains or other taxable income. This lowers the tax bill the investor pays in that year, allowing them to reinvest the money they earned back into their portfolio.
How do tax losses work? ›
Losses on your investments are first used to offset capital gains of the same type. So, short-term losses are first deducted against short-term gains, and long-term losses are deducted against long-term gains. Net losses of either type can then be deducted against the other kind of gain.
What is an example of a tax-loss carry forward? ›
For a simple example of the NOL carryforward rules post-TCJA, suppose a company lost $5 million in 2022 and earned $6 million in 2023. Its carryforward limit for 2023 would be 80% of $6 million, or $4.8 million.
However, there is no such grace period for tax-loss harvesting. You need to complete all of your harvesting before the end of the calendar year, Dec. 31. So set that egg timer and get to work.
How many years can capital loss be carried forward? ›
In general, you can carry capital losses forward indefinitely, either until you use them all up or until they run out. Carryovers of capital losses have no time limit, so you can use them to offset capital gains or as a deduction against ordinary income in subsequent tax years until they are exhausted.
How often should you do tax-loss harvesting? ›
Since many investors and financial advisors perform their tax-loss harvesting activity once a year, at the end of the year, let's look at the effectiveness of this strategy. The U.S. stock market, based on the S&P 500 Index, has ended the year positive more than 70% of the time since 1926.
At what age do you not pay capital gains? ›
Capital Gains Tax for People Over 65. For individuals over 65, capital gains tax applies at 0% for long-term gains on assets held over a year and 15% for short-term gains under a year. Despite age, the IRS determines tax based on asset sale profits, with no special breaks for those 65 and older.
What is the 6 year rule for capital gains tax? ›
Here's how it works: Taxpayers can claim a full capital gains tax exemption for their principal place of residence (PPOR). They also can claim this exemption for up to six years if they move out of their PPOR and then rent it out. There are some qualifying conditions for leaving your principal place of residence.
What is the maximum capital loss for the IRS? ›
Deducting Capital Losses
If you don't have capital gains to offset the capital loss, you can use a capital loss as an offset to ordinary income, up to $3,000 per year. If you have more than $3,000, it will be carried forward to future tax years." Here are the steps to take when it comes to tax filing season.
What products are tax-loss harvesting? ›
Tax-loss harvesting is the process of selling securities at a loss to offset a capital gains tax liability in a very similar security. Using ETFs has made tax-loss harvesting easier because several ETF providers offer similar funds that track the same index but are constructed slightly differently.
What is an example of tax gain harvesting? ›
Tax gains harvesting is when you recognize a gain on the sale of securities to incur a smaller amount of tax on that sale. For example, should you have capital losses from current or prior years, you may recognize gains up to the amount of that loss, without incurring additional capital gains tax.
How much capital gains can I offset with losses? ›
If your capital losses exceed your capital gains, the amount of the excess loss that you can claim to lower your income is the lesser of $3,000 ($1,500 if married filing separately) or your total net loss shown on line 16 of Schedule D (Form 1040), Capital Gains and Losses.
What happens when you sell stock at a loss? ›
Stocks sold at a loss can be used to offset capital gains. You can also offset up to $3,000 a year of ordinary income. A silver lining of investment losses is that you can lower your tax liability as a result.
