Tax-Loss Harvesting: Definition and Example

What Is Tax-Loss Harvesting?

Tax-loss harvesting is the timely selling of securities at a loss to offset the amount of capital gains tax owed from selling profitable assets. This strategy is commonly used to limit short-term capital gains, commonly taxed at a higher rate than long-term capital gains, to preserve the value of the investor’s portfolio while reducing taxes.

How Tax-Loss Harvesting Works

Tax-loss harvesting is also known as tax-loss selling. Most investors use this strategy at the end of the year when they assess the annual performance of their portfolios and its impact on their taxes. An investment that shows a loss in value can be sold to claim a credit against the profits that were realized in other assets.

Tax-loss harvesting is a tool for reducing overall taxes. A loss in the value of Security A could be sold to offset the increase in the price of Security B, thus eliminating the capital gains tax liability of Security B. Using the tax-loss harvesting strategy, investors can realize significant tax savings.

Maintaining Your Portfolio

Selling an asset at a loss disrupts the balance of the portfolio. After tax-loss harvesting, investors with carefully constructed portfolios replace the asset sold with a similar asset to maintain the portfolio's asset mix and expected risk and return levels. You should avoid buying the same asset that you just sold at a loss, which may violate the IRS wash-sale rule.

The Wash-Sale Rule

The wash-sale rule requires that investors avoid buying the same stock sold at a loss for tax purposes. A wash sale involves the sale of one security and, within 30 days, purchasing a substantially identical stock or security. If a transaction is considered a wash-sale, it cannot be used to offset capital gains, and if wash-sale rules are abused, regulators can impose fines or restrict the individual's trading.

Using ETFs that track the same or similar indexes can be used to replace one another while avoiding violating the wash sale rule in a tax-loss harvesting strategy. If you sell one S&P 500 index ETF at a loss, you can buy a different S&P 500 index ETF to harvest the capital loss.

Example of Tax-Loss Harvesting

Assume a single investor earns an income of $580,000 in 2023. The investor's marginal income tax rate is 37% and is subject to the highest long-term capital gains tax category, where gains are taxed at 20%. Short-term capital gains are taxed at the investor's marginal rate.

Below are the investor's portfolio gains and losses and trading activity for the year:

Portfolio:

• Mutual Fund A: $250,000 unrealized gain, held for 450 days
• Mutual Fund B: $130,000 unrealized loss, held for 635 days
• Mutual Fund C: $100,000 unrealized loss, held for 125 days

Trading Activity:

• Mutual Fund E: Sold, realized a gain of $200,000. Fund was held for 380 days
• Mutual Fund F: Sold, realized a gain of $150,000. Fund was held for 150 days

The tax owed from these sales is:

• Tax without harvesting = ($200,000 x 20%) + ($150,000 x 37%) = $40,000 + $55,500 = $95,500

If the investor harvested losses by selling mutual funds B and C, the sales would help to offset the gains, and the tax owed would be:

• Tax with harvesting = (($200,000 - $130,000) x 20%) + (($150,000 - $100,000) x 37%) = $14,000 + $18,500 = $32,500

The Bottom Line

Tax-loss harvesting is the timely selling of securities at a loss to offset the amount of capital gains tax owed from selling profitable assets. An individual taxpayer can write off up to $3,000 in net losses annually. For more advice on how to maximize your tax breaks, consider consulting a professional tax advisor.