How Tax-Loss Harvesting Works for Average Investors

Tax-loss harvesting (TLH) is a strategy to lower current taxes paid to the U.S. federal government by deliberately selling an investment at a loss—i.e., deliberately taking a capital loss—in order to use that loss to offset taxes owed on an investment sold at a profit—i.e., a capital gain—or even taxes owed on personal income. The investment can be any tradable security (stocks, bonds, shares in an exchange-traded fund) or even cryptocurrencies. Tax-loss harvesting is relevant only for taxable investment accounts—and the benefit is tax deferral—not tax cancellation.

Although the Internal Revenue Service (IRS) allows the deduction of capital losses to offset taxes owed on capital gains, both advocates and critics of tax-loss harvesting agree that it is only appropriate for certain taxpayers in certain scenarios—and both agree that all taxpayers should consult an investment tax professional before attempting TLH.

Advocates position the technique as a hedge against market downturns—a shrewd way to turn a negative into a positive. Critics caution that executing tax-loss harvesting correctly requires expertise and that the strategy can easily backfire—even on investment professionals.

Key Takeaways

  • Tax-loss harvesting is a strategy to lower current federal taxes by deliberately incurring capital losses to offset taxes owed on capital gains—or even taxes owed on personal income.
  • Tax-loss harvesting only defers tax payments—it does not cancel them.
  • If an investor has no capital gains to offset in the year the capital loss was “harvested,” the loss can be carried over to offset future gains or future income—there is no expiration date.
  • For small investors, one study found that tax-loss harvesting delivered a wide range of outcomes—with 40% of the variation driven by uncontrollable factors in the return environment and 60% driven by individual differences in the investor profiles.
  • Advocates position tax-loss harvesting as a shrewd way to turn a negative into a positive; critics caution that tax-loss harvesting requires expertise and that the strategy can easily backfire—even on investment professionals.

Capital Losses to Offset Capital Gains and Personal Income

A capital gain (or a capital loss) is the difference between the cost basis—what a taxpayer paid for an investment—and the sale price—what they later earn when they sell it. For example, as soon as an investor sells stock with a cost basis of $25,000 for $27,000, they have realized a capital gain of $2,000—and that gain is taxable in the year they sold the stock and took the profit.

This is where the IRS-approved strategy of tax-loss harvesting comes into play. The investor who realized a capital gain of $2,000 can deliberately sell one of their other investments at a loss to offset the gain on their tax return. For example, if the same investor had another stock that they bought for $30,000 and then sold for $25,000 when the price dropped, they can “harvest” that price difference of $5,000 as a capital loss. (For tax purposes, a capital loss is not considered realized until the investment has been sold for a price lower than the cost basis.)

Not only can capital losses offset capital gains, but—if losses exceed gains that year—the investor could also use the remaining capital-loss balance to offset personal income—or even carry the loss over to offset gains in future years.

Although tax-loss harvesting can be—some say should be—done throughout the year, the most common time is year-end, when annual income taxes are looming. Of course, December 31 is the deadline to take the capital losses that will be used to offset capital gains for that year, so that adds to the urgency. However, according to advocates, the danger of waiting until year-end for all TLH trades is that a capital loss that was available to be harvested in June may no longer be available in December.

Tax-Loss Harvesting Only Postpones Tax Obligations

Tax-loss harvesting is relevant only for taxable investment accounts—and it is important to remember that the benefit of TLH is not that the tax obligation is cancelled. The benefit is the same one offered by tax-deferred accounts: the tax obligation is postponed. The rationale behind tax-loss harvesting is that deferring current tax payments allows investors to use the savings to fuel portfolio growth in the present—and the assumption is that the dollar amount generated over the years will be significantly more than the eventual tax bill when it comes due.

The Lower the Cost Basis, the Higher the Tax Bill

Another important consideration for investors is that—although tax-loss harvesting can reduce the tax bill due this year—the process automatically lowers the cost basis of the investment—which could result in a higher bill on future capital gains.

As explained above, a capital gain (or a capital loss) is the difference between the cost basis—what a taxpayer paid for an investment—and the sale price—what they later earn when they sell it. When the cost basis goes down, capital gains go up—and so does the future tax bill.

Here is an example of how tax-loss harvesting lowers the cost basis:

  • An investor harvests a capital loss by selling an investment with a cost basis of $30,000 when the price drops to $25,000.
  • If they use the resulting capital loss of $5,000 (cost basis of $30,000 minus sale price of $25,000) to offset the same amount of capital gains, they could lower this year’s tax bill by $750. (This assumes that their tax rate on long-term capital gains is 15%: $5,000 x 15% = $750.)

In this example, tax-loss harvesting has worked this year, but that tax savings of $750 is not necessarily permanent over the long term—because harvesting the capital loss has lowered the cost basis, as follows:

  • The logical next step for the investor is to reinvest the $25,000 from the asset sold at a loss into a new security—which now has a lower cost basis of $25,000 (down from $30,000).
  • If the value of the new investment increases to $30,000 by the time the portfolio is liquidated (sold for cash), the investor will have incurred a capital gain of $5,000 (due to the lower cost basis of $25,000)—and the tax savings of $750 this year will be wiped out on a future tax bill (assuming their tax rate stays the same).
  • However, if the value of the new investment increases above $30,000 to $35,000, then the investor will have lost money—despite the value increase. The reason is that the capital gains bill at liquidation will be calculated by subtracting the sale price of $35,000 from the lower cost basis of $25,000, for a capital gain of $10,000, which will be taxed at 15% for a total due of $1,500—twice the amount of taxes saved by harvesting the loss this year.
  • Of course, if the new investment drops even further (instead of increasing), there are additional opportunities for tax-loss harvesting, but buying losing investments should never be the objective.

The caution for investors is that, from the time the capital loss is harvested until the tax bill comes due at portfolio liquidation, tax rates can change, personal income can go up or down, and the market can fluctuate—but taxes on capital gains will always be calculated on the cost basis of the investment. The fact that tax-loss harvesting automatically lowers the cost basis could make the strategy deliver no benefit—or even create a loss—as in the examples above.

Short-Term vs. Long-Term Tax Rates

Whenever a capital gain or a capital loss is realized, it is classified by the IRS as either short-term (on assets held for less than a year) or long-term (on assets held for more than a year). From a tax-loss harvesting perspective, the most important short-term/long-term considerations are:

  • All decisions about tax-loss harvesting must take into consideration that tax rates are much higher on short-term capital gains than on long-term capital gains.
  • Short-term capital gains are taxed as ordinary income at the marginal tax rate, which can be up to 37%, depending on income bracket.
  • For most individuals, long-term capital gains are taxed at a rate of 15% to 20%, depending on income.
  • For investors with income tax rates higher than their long-term capital gains tax rates, it might make sense to use capital losses to offset income rather than capital gains.
  • For investors with income below certain levels—$40,400 for single filers or $80,800 for married couples filing jointly—capital gains are taxed at 0%.

Allowances and Restrictions on Tax-Loss Harvesting

Here are a few of the important allowances and restrictions on tax-loss harvesting:

TLH Annual Tax Deduction Limit of $3,000: There is an annual limit of $3,000 on tax-loss harvesting for income tax deductions. A taxpayer may only deduct up to $3,000 ($1,500 if you are married and filing a joint return) or your total net loss shown on Line 16 of your Form 1040, Schedule D. Any total net loss on line 16 that is not used in the current tax year may be carried forward.

No Expiration Date on Capital Losses: In the example above, the investor can use their capital loss of $5,000 dollar for dollar to offset their entire capital gain of $2,000 this year—and the remaining capital-loss balance of $3,000 can be carried over to offset future capital gains (or income) until it is used up—there is no expiration date. In fact, even if the investor had no gains to offset that year, any capital losses they decided to harvest would carry over to future years until they are needed.

Losses Must First Offset Gains of Same Type: Another important consideration is that losses of one type must be used first to offset gains of the same type. Short-term capital losses must be used first to offset short-term capital gains; long-term capital losses must be used first to offset long-term capital gains. Fortunately, if losses in one category exceed gains in the same category, then the remaining losses can be applied to gains in the other category. Of course, due to the large difference in tax rates, the most profitable way for most investors to apply tax-loss harvesting is to use short-term losses to offset short-term gains.

The Wash-Sale Rule

Of all the restrictions on tax-loss harvesting, the wash-sale rule requires the most planning. This is how it works.

Most investors who use tax-loss harvesting to lower their taxes want to maintain their level of exposure to the sector in which they took capital losses. Although reinvesting after realizing capital losses is allowed, investors must be careful not to violate the wash-sale rule—or the IRS will disallow the offset of capital gains. Here are the most important considerations for investors who want to stay both invested and compliant:

60-Day Waiting Period: To prevent investors from gaming the system to get a tax break, the tax code prohibits investors from deducting capital losses on what the IRS calls "wash sales," i.e., using a capital loss for tax-loss harvesting and then repurchasing the identical security (or a “substantially identical” security) within 60 days of the sale that generated the capital loss. This means that investors must refrain from purchasing an identical or “substantially identical” security—or even an option to buy such securities—for 30 days before and 30 days after the capital loss is realized.

Stock Bonuses and ESPPs: In addition to options, investors need to be aware that the vesting dates of stock bonuses or the purchase dates in employee stock purchase plans (ESPPs) could possibly trigger violations of the wash-sale rule.

Wash-Sale Rule Applies to All Accounts: It is also important to remember that the wash-sale rule applies to all trades under the investor's or the couple's social security number(s)—which means that it applies to all their tax-deferred accounts, too. This means that an investor will trigger a wash-sale violation if they sell a stock in their brokerage account and buy the same stock in their IRA account within the 60-day waiting period. For married couples filing jointly, spouses are not allowed to use each other's accounts to get around the wash-sale rule.

IRS-Compliant Replacement Securities: Financial experts caution that 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. With limited guidance from the IRS, investors trying to avoid wash-sale violations always have to consider the degree of overlap with the original investment. To maintain exposure to the industry of the security sold at a loss—within the 60-day window but without violating the wash-sale rule—one of the options for investors is investing in an exchange-traded fund (ETF) or a mutual fund that targets the same sector.

Sitting on the Sidelines Can Be Costly: The wash-sale rule is cited by critics as a reason that many investors should think twice before attempting tax-loss harvesting. Markets can move a lot in 60 days, and if an investor hasn’t found an IRS-compliant replacement security, the profits they miss by sitting on the sidelines with insufficient investment in a hot sector could be greater than their TLH tax savings.

Cryptocurrency and the Wash-Sale Rule: Although cryptocurrency trades must be reported on tax returns as capital losses or capital gains, the IRS still considers cryptocurrency a property rather than a security (as of July 2022), so the wash-sale rule does not apply. In the crypto market, an investor could do exactly what the wash-sale rule disallows for securities—sell cryptocurrency at a loss, buy back the same cryptocurrency without observing the 60-day waiting period, and then use the capital loss to offset capital gains. However, according to the Wall Street Journal in June 2022, as the U.S. Congress considers options to regulate the crypto market, the classification of cryptocurrency as a property may change.

When Tax-Loss Harvesting Works

The rationale for the tax postponement is that a dollar today is worth more than a dollar in the future—especially if the money saved on taxes this year is wisely reinvested and builds more wealth than the amount of any future tax bill at liquidation. When tax-loss harvesting works as planned, the reinvested tax savings can drive the growth of a portfolio, even if the taxpayer makes no further contributions to the account.

As mentioned above, both advocates and critics agree that tax-loss harvesting is appropriate only for certain taxpayers in certain scenarios. The general guidelines include anyone with a taxable investment account and taxable income over the limits set by the tax code—as long as they have a fairly long investment horizon.

In all scenarios, it is important to remember that tax-loss harvesting does not permanently eliminate the requirement to pay taxes on capital gains—it only postpones it. As soon as the taxable account is liquidated, taxes are due on any capital gains—and the tax rate of the liquidation date applies.

Fintech Cuts Transaction and Administrative Costs

Whenever trades are executed—including tax-loss harvesting trades—costs hit the account: both transaction costs (for commissions and bid-ask spreads) and administrative costs (for trade execution and regulatory filings). For years, critics of the widespread implementation of tax-loss harvesting have argued that the TLH was appropriate only for larger accounts (both institutional and individual), where these costs are a “smaller percentage drag on the portfolio.”

On the other side of the debate, a 2020 study conducted by the MIT Laboratory for Financial Engineering made the point that recent advances in financial technology (fintech) and the overall decline in computing costs have lowered (or even eliminated) the transaction and administrative costs that often used to wipe out the benefits of TLH tax savings for small investors.

Now that fintech (especially at robo-advisors) has removed the cost barrier, the MIT analysts argued that tax-loss harvesting has become practical for small accounts as well as large investors—and that fintech has the potential to drive TLH the same way it stimulated the growth of index funds and the options market.

When Tax-Loss Harvesting Doesn’t Work

Critics argue that pro-TLH theories assume ideal conditions for factors that are highly unpredictable in the real world. For example, postponing tax payments works only if tax rates (for both capital gains and the individual taxpayer) remain at the same level (or drop)—and tax rates can never be predicted, especially over the lifetime of most investment portfolios. When tax-loss harvesting backfires, the taxpayer can wind up with a future tax bill that is far higher than any profits from reinvested tax savings.

Critics of the widespread use of tax-loss harvesting also argue that small investors do not have the large, frequent capital gains that make TLH profitable for large investors, so capital losses might just accumulate indefinitely without lowering taxes. In fact, a frequently cited study published in the Financial Analysts Journal found that 40% of what determines how profitable TLH is to small investors is driven by uncontrollable factors in the return environment and the remaining 60% of the variation is driven by differences in individual investor profiles (income, tax rates, cash contributions/liquidations, percentage of income offset with losses).

For this reason, the analysts on this study advocated a case-by-case approach to tax-loss harvesting, especially for average investors. TLH should be tailored to individual tax and income profiles—exactly as investment advisors do when they match asset allocation and risk profile to each investor’s investment objectives and time horizons.

Does Tax-Loss Harvesting Cancel Tax Obligations?

Tax-loss harvesting (TLH) does not cancel tax obligations; TLH only postpones the tax bill, in the same way that tax-deferred accounts do.

What Is the Point of Tax-Loss Harvesting?

If executed correctly, tax-loss harvesting allows investors to lower their current tax bill, rebalance their portfolios, and keep more money invested.

What Is the Wash-Sale Rule?

The wash-sale rule is an IRS regulation that prohibits investors from using a capital loss for tax-loss harvesting if the identical security, a “substantially identical” security, or an option on such a security has been purchased within 60 days of the sale that generated the capital loss (30 days before and 30 days after the sale).

What Is the Difference Between Short-Term and Long-Term Capital Gains?

The most importance difference is that the tax rate on short-term capital gains (on assets held for less than a year) is much higher than the tax rate on long-term capital gains (on assets held for more than a year).

What Is the Tax-Loss Harvesting Process?

The three steps in the tax-loss harvesting process are: 1) selling securities that have lost value; 2) using the capital loss to offset capital gains on other sales; 3) replacing the exited investments with similar (but not too similar) investments to maintain the desired investment exposure.

The Bottom Line

Tax loss harvesting is the strategic approach to making the most of capital losses. Due to tax treatment of gains and losses, taxpayers may find it favorable to time when they sell securities at a loss and how they net this activity against favorable investment gains. Tax loss harvesting also strongly relates to wash sale rules which stipulate restrictions on benefits and treatments of selling a security and rebuying it within a specific window.

Article Sources
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