Tax-Loss Harvesting Strategy

Tax-loss harvesting is the practice of selling assets at a loss to offset capital gains and reduce tax liability in the current year—or carry the loss forward to future years. The strategy is straightforward: if you have both winners and losers in your portfolio, realize the losses to cancel out the gains. The constraint is the wash-sale rule: if you rebuy the same or substantially identical security within 30 days, the loss is disallowed, though it’s added to the basis of the new position, deferring the tax benefit.

How Loss Harvesting Works

Suppose you have a taxable brokerage account with two stock positions:

• Stock A: Bought at $10,000; now worth $15,000 (unrealized gain of $5,000)
• Stock B: Bought at $10,000; now worth $7,000 (unrealized loss of $3,000)

During the year, you sell Stock A and realize a $5,000 capital gain. Without loss harvesting, you would owe tax on the full $5,000. But you can sell Stock B at the same time and realize the $3,000 loss, which offsets $3,000 of the gain. Your net capital gain is $2,000, and you owe tax only on that amount.

If you’re in the 15% long-term capital gains bracket, the tax on $5,000 is $750, and the tax on $2,000 is $300—a savings of $450 just by realizing a loss that was already embedded in the portfolio.

The key insight: losses have value. An underwater position that you were going to hold passively instead becomes a tax asset that you can deploy to offset gains.

Offset Mechanics: Gains and Losses

Capital losses are powerful because they offset capital gains dollar-for-dollar, regardless of the holding period of either the gain or the loss.

Long-term loss vs. long-term gain: A $5,000 long-term loss cancels out a $5,000 long-term gain.

Short-term loss vs. short-term gain: A $5,000 short-term loss cancels out a $5,000 short-term gain.

Short-term loss vs. long-term gain: A $5,000 short-term loss cancels out a $5,000 long-term gain. The short-term loss does not “downgrade” the long-term gain; it just reduces the amount of gain taxed.

Long-term loss vs. short-term gain: Similarly, a $5,000 long-term loss can offset $5,000 of short-term gain.

This flexibility is valuable. A portfolio manager can harvest losses from any underwater position to offset gains from any winner, regardless of the time horizon of either position.

The $3,000 Annual Limit on Ordinary Income

Capital losses can offset capital gains in full. But if losses exceed gains in a year, only $3,000 of the excess loss can offset ordinary income (wages, interest, salary, etc.).

Example: You realize $10,000 of capital losses and $4,000 of capital gains in a year.

• Net loss = $10,000 − $4,000 = $6,000
• Offset against ordinary income: $3,000
• Carryforward to future years: $3,000

If you’re in the 24% tax bracket, the $3,000 offset saves you $720 in taxes this year, and you carry forward the remaining $3,000 loss.

This limit is set by Congress to prevent high-income earners from loading up on investment losses to wipe out wages or salaries. The idea is to keep capital losses in the capital realm; they’re not freely convertible to offsets on ordinary income.

Carryforward Rules

Losses that exceed the $3,000 annual cap carry forward indefinitely. They are not subject to a five-year or ten-year sunset; they wait until you have enough capital gains to absorb them, or until you can use $3,000 against ordinary income again.

This is where long-term investors benefit from loss harvesting. If you harvest $10,000 of losses in year 1 but have no gains and limited ordinary income, you pay $720 in taxes saved (at 24%). The remaining $7,000 sits in a carryforward account. In year 5, if you realize a $20,000 gain, the $7,000 loss carryforward applies first, and you pay tax on only $13,000 of gain instead.

Tracking carryforwards is critical. You must file Form 8949 and Schedule D each year, noting both realized gains/losses and any carryforward from prior years. Failure to track properly can lead to overpayment or audit risk.

The Wash-Sale Trap

The wash-sale rule is the single most important constraint on tax-loss harvesting. It prevents the strategy from being a “free” tax reduction.

The rule: If you sell a security at a loss, you cannot buy the same or a substantially identical security within 30 days before or after the sale. If you do, the loss is disallowed for the current year.

The period: 61 days total (30 days before the sale, the sale date itself, and 30 days after).

Substantially identical: The IRS does not define this with perfect precision, but generally:

• Buying the same stock after selling it is clearly prohibited.
• Buying a call option on the same stock is prohibited.
• Buying a mutual fund tracking the same index is likely prohibited (though case law is mixed).
• Buying a different stock in the same sector may not be prohibited (it depends on the specific securities).

Example: You sell Apple stock at a loss on November 15. You cannot buy Apple shares, Apple call options, or any security the IRS considers substantially identical between October 16 and December 15. If you do, the loss is disallowed.

The Bonus: Basis Step-Up on Wash Sales

If a wash sale disallows your loss, the amount of the disallowed loss is added to the cost basis of the security you repurchased. This defers the tax benefit but does not eliminate it.

Continuing the Apple example: You sold 100 shares at $90 (cost basis $100, loss $1,000). You repurchased 100 shares at $85 on November 20 (wash sale). The $1,000 loss is disallowed. But your cost basis in the new 100 shares is $95 (the $85 purchase price plus the $1,000 disallowed loss divided by 100 shares).

When you eventually sell the 100 shares at, say, $110, your gain is $15 per share (sale price $110 minus adjusted basis $95), not $25 per share. The loss has been embedded in the basis and will reduce your taxable gain.

This means wash-sale violations are not catastrophic; they postpone the tax benefit to a future sale.

Harvesting Strategy and Timing

The math is simple:

1. Identify losers: Underwater positions in your portfolio.
2. Pair them with winners: If you have realized gains elsewhere, sell the losers to offset them.
3. Avoid wash sales: Don’t rebuy the same security within 30 days.
4. Stay invested: Consider buying a similar (but not substantially identical) security to maintain your market exposure.

For example, if you hold Vanguard Total Stock Market (VTI) and it’s underwater, you could sell it and simultaneously buy a total stock market ETF from Schwab or iShares. The different issuer and composition likely avoid the wash-sale rule while keeping you in the overall market.

Alternatively, if you hold individual stocks, you could rotate into a diversified index fund in the same sector, maintaining exposure to the sector while exiting the specific position.

The timing of harvesting is flexible. Many investors harvest losses late in the year to offset gains realized throughout the year. Others harvest opportunistically whenever a position falls significantly.

Special Cases and Complications

Inherited accounts: Inherited securities receive a step-up in basis, so losses in inherited accounts are usually never harvested. The cost basis resets to fair market value on the date of death, erasing any embedded losses.

Retirement accounts: IRAs and 401(k)s do not generate capital gains or losses at all. Selling a loser in a retirement account and rebuying it has no tax effect (good and bad: you can’t harvest losses, but you also don’t need to avoid wash sales).

Margin accounts: If you have a margin loan, selling a position at a loss and repurchasing on margin might cause the IRS to treat the new position as substantially identical. Documentation is critical.

Structured products and derivatives: Some strategies use put options or inverse ETFs to harvest losses while maintaining market exposure. These are more complex and involve different tax mechanics, but the wash-sale rule still applies.

See also