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Many investors face capital gains taxes each year, especially after selling profitable stocks or mutual funds. Tax-loss harvesting offers a way to reduce that tax burden. It involves selling investments at a loss to offset capital gains, and in some cases, a limited amount of ordinary income. We'll explore how this strategy works, its rules, and why you might consider it for your portfolio.

The basic idea is simple: if you sell an investment for less than you paid for it, you have a capital loss. You can then use this loss to cancel out capital gains from other investments you've sold for a profit. For example, if you sell Stock A for a $5,000 gain and Stock B for a $3,000 loss, your net capital gain is only $2,000. This $2,000 is what you'd typically pay taxes on, rather than the original $5,000. This strategy is mostly used in taxable brokerage accounts, not in tax-advantaged accounts like a 401(k) or IRA, where gains and losses don't have an immediate tax impact. You'll want to track your cost basis carefully, which some best apps for tracking investments can help with.

Understanding the Basics of Tax-Loss Harvesting

Tax-loss harvesting involves a specific sequence of actions: identifying losing investments, selling them, and then using those losses to offset gains. This isn't about avoiding taxes entirely, but rather about deferring them or reducing the amount you owe in a given tax year. The IRS categorizes capital gains and losses as either short-term (for assets held one year or less) or long-term (for assets held more than one year). Short-term gains are taxed at your ordinary income tax rate, which can be as high as 37% for 2024. Long-term gains typically receive preferential tax rates, often 0%, 15%, or 20%, depending on your income bracket.

When you harvest losses, you first use short-term losses to offset short-term gains. Then, you use long-term losses to offset long-term gains. If you have excess losses in one category, they can then offset gains in the other. For instance, if you have $4,000 in short-term losses and $2,000 in long-term gains, you'd first offset the $2,000 long-term gain. The remaining $2,000 short-term loss could then offset any short-term gains you might have. If you have more losses than gains, you can use up to $3,000 of those net capital losses to reduce your ordinary income each year. Any remaining losses can be carried forward to future tax years. This means a loss today could still benefit you years down the line. It's a key part of smart beginners guide to investing practices.

One of the most important rules to remember is the "wash-sale rule." This rule prevents investors from selling a security at a loss and then buying the same or a "substantially identical" security within 30 days before or after the sale. If you violate this rule, the IRS disallows the loss. For example, if you sell 100 shares of Apple (AAPL) for a loss on December 1st, you cannot buy Apple stock again until January 1st of the following year. This rule applies to your spouse's accounts as well. To still maintain market exposure, investors often buy an exchange-traded fund (ETF) that tracks a similar index or a different stock in the same sector. This allows you to stay invested while adhering to the wash-sale regulations.

Practical Steps for Harvesting Losses

Executing a tax-loss harvesting strategy requires careful planning and tracking. First, review your investment portfolio for any positions currently trading below your purchase price. Many brokerage platforms or investment tracking apps provide tools that show your unrealized gains and losses. Focus on positions where the loss is significant enough to make the effort worthwhile. For someone with a $100,000 portfolio, a $50 loss might not be worth the transaction fees, but a $1,000 loss likely is.

Once you identify a losing position, decide if you want to sell it. Remember the wash-sale rule. If you sell Company X stock for a loss, you can't buy Company X stock (or a very similar fund) for 30 days. If you want to remain invested in that sector or asset class, you could purchase a non-identical but similar investment. For example, if you sell an S&P 500 index fund, you might buy a total stock market index fund. These are generally considered "not substantially identical" by the IRS, though it's always best to consult a tax professional for specific situations.

Keep detailed records of all your sales, including the date, sale price, original purchase price, and the resulting gain or loss. Your brokerage firm will provide a Form 1099-B, which reports these transactions to the IRS. However, having your own records helps ensure accuracy. You don't need to wait until December 31st to harvest losses. You can do it throughout the year, especially if you have significant gains earlier in the year that you want to offset. Some automated investment services, like Wealthfront or Betterment, offer automated tax-loss harvesting, which can simplify the process for you by continuously monitoring your portfolio for opportunities.

Benefits and Considerations

The primary benefit of tax-loss harvesting is reducing your current or future tax liability. By offsetting capital gains, you pay less in taxes, leaving more money invested and potentially growing. If you have net capital losses exceeding your gains, you can use up to $3,000 of those losses to reduce your ordinary income. This means if you're in the 22% tax bracket, a $3,000 deduction could save you $660 in taxes that year. Any losses beyond the $3,000 can be carried forward indefinitely, meaning they can offset gains or ordinary income in future years. This deferral can be incredibly powerful over decades of investing.

Consider the example of Sarah. In 2024, she sold some tech stocks for a $7,000 long-term capital gain. She also held shares of a different company, which had dropped in value, showing a $5,000 long-term capital loss. By selling those losing shares, she could offset $5,000 of her $7,000 gain, reducing her taxable gain to just $2,000. If her long-term capital gains tax rate was 15%, this saved her $750 in taxes ($5,000 * 0.15). If she had a $10,000 loss, she could offset the entire $7,000 gain, and then use $3,000 of the remaining $3,000 loss to reduce her ordinary income, saving her even more.

However, tax-loss harvesting isn't without its considerations. The main drawback is that you're selling an investment that has declined. While you might replace it with a similar investment, you're still realizing a loss. This strategy is most effective when you're selling an investment you no longer have strong conviction in, or if you plan to rebalance your portfolio anyway. Another point to remember is the potential for increased trading activity, which could lead to more transaction fees if your brokerage charges them. Many modern brokers like Fidelity, Charles Schwab, and Vanguard offer commission-free stock and ETF trades, which mitigates this concern for many investors. Always consult a tax advisor to understand how these strategies apply to your specific financial situation, especially given the complexities of the wash-sale rule and different asset classes.

Tax Implications and Best Practices

The tax implications of harvesting losses extend beyond the immediate year. While you reduce current taxes, you also reduce your cost basis on any replacement security. If you repurchase a similar security at a lower price, and it later recovers, your eventual taxable gain on that replacement security might be larger. This isn't necessarily a bad thing, as you've deferred taxes, allowing your money to grow longer. It's typically better to pay taxes later rather than sooner, especially if you can invest the tax savings.

A smart practice is to perform tax-loss harvesting towards the end of the year, usually in November or December. This allows you to have a clear picture of your gains and losses for the entire year. However, don't wait until the very last day of December; settlement times for trades can sometimes push the transaction into the next tax year. Most brokerages require trades to settle by December 31st to count for that year's taxes, which usually means placing the trade a few business days beforehand. For example, if December 31st is a Friday, you'd want to place your trade by Tuesday or Wednesday of that week.

Another best practice is to diversify your portfolio. This not only manages risk but also creates more opportunities for tax-loss harvesting. If you hold a variety of assets, from individual stocks to sector-specific ETFs and broad market funds, you'll likely have more individual positions that might be temporarily down, allowing you to selectively realize losses without selling off your entire portfolio. For those just starting out, understanding beginners guide to investing principles goes hand in hand with learning these tax strategies. Finally, always keep excellent records. Tax software programs like TurboTax or H&R Block can import your 1099-B forms, simplifying tax preparation, but knowing the details of your transactions helps ensure accuracy and allows you to answer any questions from the IRS if they arise.

FAQ

What is the wash-sale rule?

The wash-sale rule prevents you from claiming a loss on a security if you buy a "substantially identical" security within 30 days before or after the sale. This rule aims to stop investors from selling and immediately repurchasing the same asset just to claim a tax loss. For instance, if you sell Meta Platforms (META) stock for a loss on December 5th, you cannot buy META again until January 5th of the next year.

Can I use tax losses to offset ordinary income?

Yes, after offsetting all capital gains, you can use up to $3,000 of net capital losses to reduce your ordinary income each year. Any remaining losses can be carried forward indefinitely to future tax years. If you're in the 24% tax bracket, a $3,000 deduction for ordinary income could save you $720 in taxes.

How do short-term and long-term losses interact?

Short-term losses first offset short-term gains. Long-term losses first offset long-term gains. If you have excess short-term losses, they can then offset long-term gains. Similarly, excess long-term losses can offset short-term gains. This netting process helps minimize your total capital gains tax liability before applying the $3,000 ordinary income deduction.

What happens to unused capital losses?

Unused capital losses, meaning those exceeding your capital gains and the $3,000 ordinary income deduction in a given year, can be carried forward indefinitely. These losses can be used to offset future capital gains or up to $3,000 of ordinary income in subsequent tax years. This means a loss today can continue providing tax benefits for many years.

Sources:

  • IRS Publication 550: Investment Income and Expenses (Including Capital Gains and Losses)
  • NerdWallet: What Is Tax-Loss Harvesting?
  • Investopedia: Tax-Loss Harvesting

Last reviewed: 2026-06-23 by Editorial Team