How Tax-Loss Harvesting Can Lower Your Annual Tax Bill

Tax-loss harvesting is an investment strategy that involves selling assets at a loss to offset capital gains taxes on other investments sold for a profit. By realizing a loss, investors can reduce their annual tax liability, turning an underperforming investment into a tool for tax management.

This strategy applies only to investments held in taxable accounts, such as a standard brokerage account. Retirement accounts like 401(k)s and IRAs are not eligible because their investments already grow on a tax-deferred or tax-free basis, meaning there are no capital gains taxes to offset.

The Mechanics of Generating and Using Tax Losses

An investment loss only becomes tangible for tax purposes when the asset is sold, an event known as “realizing” the loss. Until the sale occurs, any decrease in value is considered an unrealized “paper” loss and has no impact on your tax situation. To execute a tax-loss harvest, you must sell the depreciated security, which formally establishes the capital loss that can be used on your tax return.

Once a loss is realized, the IRS has a specific order for how it must be used. Short-term losses, from assets held for one year or less, must first be used to offset short-term gains. Similarly, long-term losses, from assets held for more than one year, are first applied against long-term gains.

After this initial pairing, if any losses remain, they can be used across categories. For instance, if you have excess short-term losses after offsetting all short-term gains, you can then apply those losses against any long-term gains. Conversely, remaining long-term losses can be used to offset any remaining short-term gains.

If you still have capital losses after offsetting all of your capital gains, you can deduct up to $3,000 of the remaining net capital loss against your ordinary income, such as wages. For those who are married and file separately, this annual deduction limit is $1,500.

For example, imagine you have a $2,000 short-term gain, a $4,000 long-term gain, and you realize a $10,000 short-term loss. First, you use $2,000 of the loss to offset the short-term gain. You then use another $4,000 of the loss to offset the long-term gain. You are left with a $4,000 net capital loss, of which you can use $3,000 to reduce your ordinary income. The final $1,000 is carried forward to a future tax year.

The Wash Sale Rule

The wash sale rule is a regulation to prevent investors from claiming a tax loss on a security while effectively maintaining their position in it. A wash sale occurs if you sell a security at a loss and, within a specific period, acquire a “substantially identical” security. This rule applies to stocks, bonds, mutual funds, ETFs, and options.

The rule defines a 61-day window, which includes the 30 days before the sale for a loss, the day of the sale, and the 30 days after the sale. For example, if you sell a stock at a loss on April 30, the wash sale window runs from March 31 to May 30. Purchasing a substantially identical security during this period will trigger the rule.

Buying shares of the exact same company is a clear violation, as is buying options or contracts for the same stock. However, the IRS has not provided a rigid definition of “substantially identical,” leaving some areas open to interpretation based on individual facts and circumstances.

Certain securities are not considered substantially identical. Selling shares of one company and buying shares of a different company, even in the same industry, is not a wash sale. A common strategy involves selling an S&P 500 index ETF from one fund provider and immediately buying an S&P 500 index ETF from a different provider, as they are viewed as different securities.

When a wash sale occurs, the tax benefit of the loss is disallowed for that year. The disallowed loss is added to the cost basis of the newly purchased replacement security, which defers the tax loss until the replacement security is sold. The holding period of the original security is also added to the new one.

Reporting on Your Tax Return

To report capital asset transactions, you use Form 8949, Sales and Other Dispositions of Capital Assets. On this form, you list each sale’s details, including the asset’s description, acquisition and sale dates, sales proceeds, and cost basis. This form separates transactions into short-term and long-term.

The information from Form 8949 is then summarized on Schedule D, Capital Gains and Losses. Schedule D consolidates these totals to calculate your overall net capital gain or loss for the year, and this final figure is reported on your main tax return, Form 1040.

When a wash sale has occurred, it requires specific reporting on Form 8949. For the transaction, you must enter code “W” in column (f) and report the amount of the disallowed loss as a positive number in column (g). This adjustment ensures your tax calculations correctly reflect the deferral of the loss. Your broker will provide Form 1099-B, which summarizes your sales activity to help you complete these forms.

Advanced Considerations

Capital Loss Carryovers

If your net capital losses for a year exceed the $3,000 limit for deducting against ordinary income, the excess amount is not lost. The tax code allows you to carry these losses forward to subsequent tax years as a capital loss carryover. These losses can be used to offset capital gains in future years or be deducted against ordinary income up to the $3,000 annual limit.

The character of the loss, whether short-term or long-term, is preserved when it is carried forward. A short-term loss carryover will first offset future short-term gains, and a long-term loss carryover will first offset future long-term gains. This carryover can continue indefinitely until the full amount of the loss has been used.

State Tax Implications

The rules for tax-loss harvesting pertain to federal income taxes. Most states also levy their own income tax, and their treatment of capital gains and losses may differ from federal regulations. Some states conform to federal rules, while others have their own distinct systems for taxing investment income, which can affect the net benefit of the strategy.

Application to Different Assets

The principles of tax-loss harvesting apply broadly to assets like stocks, bonds, and ETFs. The main consideration is the “substantially identical” rule. For example, selling a corporate bond and buying another from the same issuer with a different maturity date and coupon rate is not a wash sale. This allows investors to harvest a loss while maintaining similar exposure in their portfolio.