What is Tax-Loss Harvesting?

Investing in stocks can yield great growth—but the flip side of that is that investing also involves risks. Some investments are winners, and others that looked promising initially fizzle disappointingly. But even those stocks that turn out to be duds can offer a financial benefit through tax-loss harvesting. What is tax-loss harvesting, and how does it work?

If you have a taxable investment account (in other words, not a tax-sheltered account like an IRA or 401(k), in which growth on investments is not taxed), you can sell investments that have declined in value and use that loss to reduce the amount of tax you have to pay on taxable gains from other investments. Put simply, tax-loss harvesting involves offsetting capital losses against capital gains to reduce your amount of taxable gains, and the amount of capital gains tax that you need to pay.

How Does Tax-Loss Harvesting Work?

Let’s say your investment portfolio contains Stock A, which you bought for $5,000. Unfortunately, the stock declined in value and is now worth only $4,000. However, at the same time, you also bought Stock B, which has performed better than expected, and it’s now worth $6,500. You decide to sell both stocks.

Ordinarily, you would owe capital gains tax on $1,500—the profit you made selling Stock B. But because you sold Stock A at a loss at the same time, you can “harvest” that loss, using it to reduce your capital gains by $1,000. Now you owe capital gains tax only on your net gain of $500 ($1,500 gain on Stock B minus your $1,000 loss on Stock A).

Now, let’s say you also have Stock C in your portfolio, which you bought at the same time as Stock A and Stock B. You bought Stock C at $10,000, but its value plummeted to $6,000 before you sold it. Now your total realized losses are $5,000 ($1,000 from Stock A and $4,000 from Stock C), but your realized gains are only $1,500 from Stock B. The good news is that your capital losses have wiped out your capital gains for the year, so you won’t owe any capital gains tax.

But you still have $3,500 of realized losses, and no more capital gains against which to offset them. Are those losses wasted? Not necessarily. You can use it to reduce the amount of your taxable ordinary income by up to $3,000 (or $1,500 for married spouses filing separately). So if your ordinary income (not capital gains) is $80,000, you can reduce it to $77,000 with your $3,000 loss.

Even then, though, you still have $500 of loss left over, and that can reduce your taxes, too—just not in the same year. You can carry that extra $500 forward to the next year, using it to offset capital gains if you have any, or ordinary income if you don’t.

What You Need to Know About Tax-Loss Harvesting

Tax-loss harvesting sounds like a great tool for reducing your tax bill, and it is. However, there are also a number of things you should keep in mind when considering this approach.

Taxable Investment Accounts Only

As mentioned above, tax-loss harvesting can only be used with taxable investment accounts, not tax-sheltered investment accounts like tax-sheltered retirement accounts. The IRS does not tax the gain on investments in these accounts, so let them grow, let them grow, let them grow!

Beware the Wash-Sale Rule

The idea of taking a loss on a sale for tax-loss harvesting purposes may appeal to you, but what if you really want to keep that stock? You may get the idea to sell it, take the loss, then buy it right back at the lower price. Then you would get to take the tax loss, but still benefit from having the stock, right? Not so fast: you have to be mindful of the wash-sale rule.

The wash-sale rule is an IRS regulation designed to prevent people from taking unfair advantage of tax-loss harvesting by purchasing the same (or a substantially identical) stock within a limited period. If you purchase the stock within thirty days before or thirty days after the sale, the loss from the sale will be disallowed for tax purposes.

Act by December 31

Unlike some tax strategies like contributing to a Roth IRA, which can be done up until the April tax filing day to reduce the previous year’s taxes, tax-loss harvesting must be done by December 31 of the tax year. So, if the end of the year approaches and you realize you’re likely to have capital gains from the sale of securities that year, you might want to speak with your tax attorney about (quickly) harvesting some tax losses.

Short-Term vs. Long Term Capital Gains

Not all capital gains are created equal. Long-term gains are those on investments you have held for longer than a year; they are taxed at much more favorable rates than short-term capital gains, those on assets sold after less than a year. Short-term capital gains are taxed as ordinary income. If you sell an investment at a loss, that loss will first be applied to offset a gain of the same type. So a long-term capital loss won’t be used to offset a short-term capital gain, unless you have no long-term capital gains.

Just Because You Can, Doesn’t Mean You Should

If you sell a stock at a loss, you can use that loss to offset a gain and save on taxes. But that doesn’t always mean selling at a loss is a good strategy. If you believe that the stock has peaked and is unlikely to rebound, then selling makes sense. But if the stock has potential for growth, you could do better by simply hanging onto it and waiting. You may get a much greater benefit from its eventual increase in value than from taking the tax loss now.

Consult an Experienced Tax and Estate Planning Attorney

Tax strategy never takes place in a vacuum. There are a lot of moving parts, and you should never act without understanding all the potential consequences of your actions. To learn more about tax-loss harvesting and other tax strategies, contact Gudorf Law Group to schedule a consultation.