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 an example of a tax harvesting loss? ›
An example of tax-loss harvesting
Consider this hypothetical example1: You bought stock or mutual fund shares for $10,000 that have now fallen in value to $6,000. You also bought another stock or mutual fund for $8,000, but it has performed well and is now worth $15,000.
How to do tax-loss harvesting step by step? ›
The three steps in the tax-loss harvesting process are: 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 the desired investment exposure.
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.
How do you write off stock losses on your taxes? ›
You must fill out IRS Form 8949 and Schedule D to deduct stock losses on your taxes. Short-term capital losses are calculated against short-term capital gains to arrive at the net short-term capital gain or loss on Part I of the form.
What is the downside of 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. The $3,000 loss limit rule can be found in IRC Section 1211(b). For investors with more than $3,000 in capital losses, the remaining amount can't be used toward the current tax year.
Do you get money back from tax-loss harvesting? ›
Tax-loss harvesting helps investors reduce taxes by offsetting the amount they have to claim as capital gains or income. Basically, you “harvest” investments to sell at a loss, then use that loss to lower or even eliminate the taxes you have to pay on gains you made during the year.
What are examples of capital losses? ›
Understanding a Capital Loss
For example, if an investor bought a house for $250,000 and sold the house five years later for $200,000, the investor realizes a capital loss of $50,000. For the purposes of personal income tax, capital gains can be offset by capital losses.
How much loss can you claim on taxes? ›
The IRS limits your net loss to $3,000 (for individuals and married filing jointly) or $1,500 (for married filing separately). Any unused capital losses are rolled over to future years.
Robo-advisor tax-loss harvesting is the automated selling of securities in a portfolio to deliberately incur losses to offset any capital gains or taxable income.
What is an example of a tax-loss carry forward? ›
Imagine a company lost $5 million one year and earned $6 million the next. The carryover limit of 80% of $6 million is $4.8 million. The full loss from the first year can be carried forward on the balance sheet to the second year as a deferred tax asset.
What is the 30 day rule for tax-loss harvesting? ›
If you sell a security at a loss and buy the same or a substantially identical security within 30 calendar days before or after the sale, you won't be able to take a loss for that security on your current-year tax return.
How many years can stock losses be carried forward? ›
If the net amount of all your gains and losses is a loss, you can report the loss on your return. You can report current year net losses up to $3,000 — or $1,500 if married filing separately. Carry over net losses of more than $3,000 to next year's return. You can carry over capital losses indefinitely.
How much stock loss can you write off for married filing jointly? ›
You can, but only up to a set limit. The IRS allows you to deduct up to $3,000 in losses if you're filing as a single individual or filing jointly. If you're married but filing jointly, you can deduct $1,500. Anything more than these limits can be carried over and deducted from your taxable income in the next year.
Can you write off worthless stock? ›
Bottom line. If you have a worthless asset, you can claim your tax write-off and reduce your taxable income. But it's important that you follow the IRS procedures, because your brokerage may not report your loss on worthless securities that remain in your account if you can't dispose of them.
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.
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.
How many years can you carry forward capital losses? ›
If the net amount of all your gains and losses is a loss, you can report the loss on your return. You can report current year net losses up to $3,000 — or $1,500 if married filing separately. Carry over net losses of more than $3,000 to next year's return. You can carry over capital losses indefinitely.
