Tax-loss harvesting is a strategy of strategically selling certain assets at a loss to neutralize capital gains and limit your tax liability. Investors often evaluate their portfolios toward the end of the year to look for opportunities to apply this strategy.
If you have more in losses than you do in capital gains, you can eliminate your capital gains tax entirely and apply up to $3,000 of remaining losses toward reducing your taxable income.
To use a simplified example, let’s say you have long-term holdings in equities that would bring a $10,000 loss if sold and you made $6,000 in long-term capital gains on other holdings. You could sell your holdings for the $10,000 loss, completely wipe out your tax on the capital gains, and reduce your taxable income by $3,000. You can even carry over $1,000 in losses to next year and apply them toward next year’s taxes.
You have still come out with a net loss on assets – but you had lost that money already without a rebound in asset value, and you have minimized the effect by saving on your taxes.
When should you take advantage of tax-loss harvesting? It does not make sense unless you have holdings that you really want to sell at a loss – stocks or fixed income investments that are worth less than the price you paid for them (known as the cost basis) and that you do not expect to rebound in any useful way. One could argue you are actually “culling” weak investments and “harvesting” as much value as you can get from them.
Consider what you are going to purchase to replace the investments that you sell. You may not want to sell if doing so completely upsets the risk balance in your portfolio.
You can replace the investments with better performers in the same risk category, but you must wait 30 days before buying back the same stock or one that is “substantially identical” to the previous stock. The IRS “wash sale” rule applies to keep people from dumping investments at the end of the year as a tax dodge and repurchasing them immediately.
The next factor to consider is your total short-term vs. long-term capital gains. Long-term gains are profits from selling investments that you have held for longer than a year, and are taxed at lower rates (15% or 20% depending on your tax bracket). Short-term gains are profits on investments sold within a year of purchase that are taxed at the ordinary rate for your tax bracket.
The IRS requires that you tabulate all short-term and long-term gains and losses separately (known as “netting”), and then you may offset total gains in one category against total losses in the other. The best result is that you have a long-term capital loss and short-term capital gains, because in that case your losses are negating higher-taxed gains.
What if you have long-term gains that you could reduce with short-term sales losses? It may still work out best for you to take that action, but you need to do a cost-benefit analysis to be sure. The transaction fees may neutralize most of your tax savings, or the outlook for the asset may be tempting enough to convince you to hold on to it and reassess the situation in the next tax year.
Make sure you understand the true cost basis when making your analysis, because the cost basis is not always straightforward. For example, if you have bought a particular stock multiple times and you only want to sell some of the shares for a loss, how do you know which shares are which? Unless you specified identification of individual stock shares, your broker probably uses an average cost method or a FIFO (first in, first out) method. You may over/underestimate the effect of a sale if you are using the wrong basis.
If you are not sure about some aspect of tax-loss harvesting – for example, you are unsure if a replacement stock could be considered substantially identical or you are having trouble determining the cost basis of an asset – consult with a tax professional before proceeding.
In summary, you want to apply tax-loss harvesting if you have assets that have lost value, are unlikely to return sufficient value in the future, and either do not fit in your investing portfolio anymore, or can be replaced with better-performing investments that match your portfolio needs.