By selling a loss-making investment at a loss, tax-loss harvesting reduces the current tax owed to the government. An intentional capital loss is made in order to deduct taxes owed on a profit or personal income tax. Investing in taxable accounts allows you to harvest losses-the benefits are tax deferral rather than tax cancellation. The most popular tradable assets are stocks, bonds, and exchange-traded funds.
In spite of the fact that capital losses can be deducted from capital gains taxes owed by the Internal Revenue Service, critics and advocates of tax-loss harvesting agree that the method is only suitable for certain taxpayers under certain circumstances and that all taxpayers should consult an investment tax professional before trying it out.
While advocates view tax-loss harvesting as a hedge against market downturns — a shrewd way to convert a negative into a positive — critics warn that it requires expertise and can easily backfire — even for investment professionals.
What You Need To Know
- Losses harvested for tax purposes are deliberately incurred to offset taxes owed to the federal government on either capital gains or personal income.
- The harvesting of tax losses only delays tax payments, not cancels them.
- There is no expiration date on capital losses if an investor has no capital gains to offset in the year the loss was “harvested.”
- An analysis of small investors found that tax-loss harvesting led to a wide range of outcomes, with 40% coming from uncontrollable factors in the return environment and 60% coming from individual investor differences.
- It is argued that tax-loss harvesting allows investors to turn a bad situation into a good one, but critics point out that the process requires expertise and that it can quickly go wrong — even for the most experienced investors.
Offsetting capital gains and personal income with capital losses
As a result of selling an investment, a taxpayer earns a capital gain (or a capital loss) based on the difference between its cost basis and its sale price. If an investor sells stock for $27,000 with a cost basis of $25,000, they realize a capital gain of $2,000 immediately—and that gain is taxable in the year they sold the stock.
When a capital gain of $2,000 is realized by an investor, they can intentionally sell one of their other investments at a loss to offset the gain on their tax return. This is where the IRS-approved strategy of tax-loss harvesting comes into play. An investor, for instance, can claim a capital loss of $5,000 if they bought a stock for $30,000 but then sold it for $25,000 when the price dropped. Unless sold for a price lower than the cost basis, a capital loss is not considered realized for tax purposes.
A number of benefits can be derived from capital losses, including the ability to offset capital gains and, if losses exceed gains, to offset personal income.
It is possible to harvest tax losses throughout the year, but the most common time is at the end of the year, when tax season approaches. The deadline for taking capital losses to offset capital gains for that year is December 31, so the urgency is even greater. According to advocates, if all TLH trades are delayed until year-end, the capital loss may no longer be available for harvest in December.
Only postponing tax obligations is the result of tax-loss harvesting
There is only one type of tax-loss harvesting: tax-deferred accounts. In both cases, the tax obligation is postponed rather than cancelled. In tax-loss harvesting, investors defer current taxes so they can use the savings to fuel portfolio growth now — and the assumption is that the dollar amount generated over the years will exceed the amount due in the future.
Taxes are higher when the cost basis is lower
Also, investors should know that while tax-loss harvesting can lower this year’s tax bill, it also lowers the investment’s cost basis, which could mean a higher capital gains tax bill next year.
The difference between a taxpayer’s cost basis, which is what they paid for a project, and the sale price, which is what they earn when they sell it, is capital gain (or capital loss). When the cost basis goes down, the amount of capital gain goes up, and so does future tax liability.
A tax-loss harvesting example shows how cost basis is lowered:
- If an investor sells an investment at a loss of $30,000 when it drops to $25,000, he harvests a capital loss.
- By reducing their tax bill by $750, they will be able to offset the same amount of capital gains by $5,000 (cost basis of $30,000 minus sale price of $25,000). Assuming a 15% tax rate on long-term capital gains, $5,000 x 15% = $700.
It has worked this year for tax-loss harvesting, but that $750 tax savings may not be permanent in the long run, as harvesting the capital loss has lowered the cost basis as follows:
- Investors should 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.
- The investor will incur a capital gain of $5,000 (because the cost basis is lower than $25,000) if the investment grows to $30,000 by the time it is liquidated (sold for cash). If the investor’s tax rate remains the same, the $750 tax savings they will save this year will be wiped out on a future tax bill.
- The investor will lose money, however, if the new investment increases above $30,000 to $35,000—despite the increase in value. A capital gains bill at liquidation is calculated by subtracting the sale price of $35,000 from the lower cost basis of $25,000, resulting in a capital gain of $10,000. The tax on this gain will be 15%, for a total due of $1,500. This is twice the amount of taxes saved by harvesting the loss.
- Buying losing investments can still be a tax-loss harvesting opportunity if the investment drops even more (instead of increasing).
Tax rates, personal income, and markets can fluctuate from the time a capital loss is harvested until the tax bill comes due at portfolio liquidation, but capital gains taxes will always be calculated on the cost basis of the investment regardless of how much the capital loss is harvested. As in the examples above, tax-loss harvesting automatically lowers the cost basis, which could result in the strategy not delivering any benefit, or even creating a loss.
Long-Term vs. Short-Term Tax Rates
As soon as a capital gain or loss is realized, it is classified as either short-term (on assets held less than a year) or long-term (on assets held longer than a year). Among the most important short-term and long-term considerations when harvesting tax losses are:
- The tax rate on short-term capital gains is much higher than the tax rate on long-term capital gains, so tax-loss harvesting must be considered in any decision about tax-loss harvesting.
- Tax rates for short-term capital gains range from 37% to 55%, depending on your income bracket.
- It is generally taxed at 15% to 20%, depending on an individual’s income, if they have long-term capital gains.
- The use of capital losses instead of capital gains might make sense for investors with higher income tax rates than their long-term capital gains tax rates.
- Capital gains are tax-free for investors with income under certain limits – $40,400 for single filers and $80,800 for married couples filing jointly.
Tax-loss harvesting allowances and restrictions
A few important tax-loss harvesting allowances and restrictions are as follows:
TLH Annual Tax Deduction Limit of $3,000: Tax-loss harvesting can be deductible for income tax purposes up to $3,000 a year. A taxpayer may only deduct up to $3,000 ($1,500 if you are married and file a separate return) or your total net loss shown on Line 16 of your Form 1040, Schedule D. If line 16 of your tax return is not used, you can carry it forward.
There is no expiration date on capital losses: According to the example above, the investor can use their $5,000 capital loss dollar for dollar to offset their entire $2,000 capital gain this year–and the remaining $3,000 can be carried over to offset future gains (or income) until it is exhausted. Any capital losses that the investor harvests will carry over to future years even if they have no gains to offset then.
It is important to note that losses of one kind must be offset by losses of the same type first. In order to offset short-term capital gains, short-term capital losses must first be offset; in order to offset long-term capital gains, long-term capital losses must first be offset. In the event that losses in one category exceed gains in the same category, the remaining losses can be applied to gains in the other. Since tax rates differ widely, most investors find it most profitable to use short-term losses to offset short-term gains when using tax-loss harvesting.
Rule of Wash-Sale
Tax-loss harvesting is restricted by a variety of rules, but the wash-sale rule is the most complex.
In order to reduce taxes, most investors who take capital losses want to keep their exposure to the sector in which they took the losses. Reinvesting after realizing capital losses is allowed, but investors must be careful not to violate the wash-sale rule—or the IRS will disallow capital gains from being offset. Investing and compliance are two important considerations for investors.
As a means of preventing investors from gaming the system to get a tax break, the tax code prohibits investors from deducting capital losses from “wash sales,” or repurchasing the security (or a security that is substantially identical) within 60 days of the sale that generated the capital loss after using a capital loss for tax-loss harvesting. A capital loss must be realized within 30 days of the purchase of an identical or “substantially identical” security-or even an option to buy them-before or after the loss is realized.
As well as options, investors need to be aware that stock bonuses and ESPPs might trigger violations of the wash-sale rule if their vesting dates overlap with their purchase dates.
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 as well. Consequently, an investor will be in violation of wash-sale rules if he or she sells a stock in a brokerage account and buys the same stock in an IRA account within the 60-day waiting period. To avoid the wash-sale rule, married couples can’t use each other’s accounts.
It is important to note that the IRS wash-sale rule does not clearly define what constitutes a replacement security that is “substantially identical” to the one sold to reap a capital loss, according to financial experts. In order to avoid wash-sale violations, investors need to consider the extent to which their original investment overlaps with the new investment despite limited IRS guidance. Investments in exchange-traded funds (ETFs) or mutual funds that target the same industry that the security sold at a loss can provide investors with exposure to the sector without violating the wash-sale rule.
Tax-loss harvesting can be costly if you sit on the sidelines: Critics point out the wash-sale rule for preventing many investors from attempting it. In 60 days, markets can move a lot, and if an investor has not found an IRS-compliant replacement security, their losses could exceed their TLH tax savings if they sit on the sidelines.
While cryptocurrency trades are required to be reported on tax returns as capital losses or capital gains (as of July 2022), the IRS still considers cryptocurrency a property rather than a security, so the wash-sale rule does not apply. The wash-sale rule for securities does not allow an investor to do exactly what cryptocurrency investors can do in the crypto market-sell cryptocurrency at a loss, buy it back without observing the 60-day waiting period, and then offset the gain with the capital loss. The Wall Street Journal reported in June 2022 that as Congress considers options to regulate the crypto market, the classification of cryptocurrency as a property may change.
Using tax-loss harvesting to its full potential
As a result of the tax postponement, a dollar today is worth more than a dollar in the future, especially if the money saved on taxes is wisely reinvested and builds more wealth than any future tax bill when liquidated. The tax savings reinvested in a portfolio can contribute to portfolio growth even if the taxpayer makes no further contributions to the account when tax-loss harvesting works as planned.
According to both advocates and critics, tax-loss harvesting can only be used by certain taxpayers in certain situations. As long as they have a fairly long investment horizon, anyone with a taxable investment account and taxable income over the limits set by the tax code is eligible for the general guidelines.
You should keep in mind that tax-loss harvesting doesn’t eliminate capital gains taxes permanently, it just postpones them. Capital gains are subject to tax as soon as the taxable account is liquidated – at the tax rate of the liquidation date.
The use of fintech reduces transaction and administrative costs
Trades, including tax-loss harvesting trades – incur costs: both transactional costs (for commissions and bid-ask spreads) and administrative costs (for trade execution and regulatory filings). Tax-loss harvesting has been criticized for years because it isn’t good for large accounts (both individual and institutional), where the costs are a “smaller percentage drag on the portfolio.”
MIT Laboratory for Financial Engineering’s 2020 study, on the other hand, argued that recent advances in fintech (fintech) and the overall decline in computing costs have lowered (or even eliminated) the transaction and administrative costs that have often eliminated the benefits of TLH tax savings for small investors.
According to the MIT analysts, tax-loss harvesting has become feasible for small and large accounts now that fintech (particularly robo-advisors) has removed the cost barrier – and fintech can encourage TLH in the same way that index funds and options markets were able to grow.
There are times when tax-loss harvesting does not work
TLH theories are criticized by critics for assuming ideal conditions for factors that are highly unpredictable in reality. As an example, postponing taxes only works if tax rates (for capital gains and individual taxpayers) remain at the same level (or drop)-and tax rates can never be predicted, especially over the lifetimes of most investment portfolios. Tax-loss harvesting can backfire when taxpayers wind up paying much higher taxes than they would have been if they had reinvested their tax savings.
Tax-loss harvesting is also criticized by critics as ineffective for small investors since they do not possess the large capital gains that make it profitable for larger investors. As a result, capital losses can accumulate without lowering taxes indefinitely. TLH’s profitability to small investors is heavily influenced by uncontrollable factors in the return environment, according to a study frequently cited in the Financial Analysts Journal. An additional 60% of the variation is accounted for by differences in investor profile (income, tax rates, cash contributions, and losses offset by income).
The analysts in this study recommended that average investors take a case-by-case approach to tax-loss harvesting. The TLH should match each investor’s investment objectives and time horizons exactly, just as investment advisors do in matching asset allocation and risk profile to each investor’s tax and income profiles.
Are tax obligations canceled when tax losses are harvested?
In the same way that tax-deferred accounts postpone tax bills, tax-loss harvesting (TLH) does not cancel tax obligations.
How Does Tax-Loss Harvesting Work?
By harvesting tax losses correctly, investors can reduce their current tax bill, rebalance their portfolios, and keep more money invested.
Wash-Sale Rule: What Is It?
In the wash-sale rule, investors are prohibited from harvesting a capital loss for tax purposes if they have purchased a security, a “substantially identical” security, or an option on a similar security within 60 days of the sale that caused the capital loss (30 days before and 30 days after the sale).
How Do Short-Term and Long-Term Capital Gains Differ?
It’s important to note that the tax rate on short-term capital gains (on assets held less than a year) is much higher than the tax rate on long-term capital gains.
How Does Tax-Loss Harvesting Work?
To harvest tax losses, three steps are involved: 1) Selling securities that have lost value; 2) Offsetting capital gains from other sales with the capital loss; and 3) Replacing the investments that were sold with similar (but not too similar) investments so that the investment exposure stays the same.
An approach to capital loss harvesting that makes the most of capital losses is tax loss harvesting. As a result of the tax treatment of gains and losses, taxpayers may find it beneficial to time when they sell securities at a loss and how they net this activity against favorable investment gains. Tax loss harvesting is also closely related to wash sale rules, which limit benefits and treatment when a security is sold and bought back within a certain time frame.
An earlier version of this article incorrectly stated that the annual income tax deduction for tax-loss harvesting was $1,500 for married couples filing jointly. The correct phrase is “married couples filing separately.”