How to Do Tax Loss Harvesting for Investment Gains
Learn how to strategically offset investment gains by harvesting losses, navigating tax rules, and maintaining accurate records for future tax benefits.
Reducing taxes on investment gains is a key strategy for maximizing long-term returns. Tax loss harvesting helps achieve this by selling investments at a loss to offset taxable gains, lowering the overall tax bill. However, following IRS rules is essential to avoid costly mistakes.
Eligible Investment Classes
Stocks, bonds, mutual funds, and exchange-traded funds (ETFs) are commonly used for tax loss harvesting since they are subject to capital gains taxation. Cryptocurrency also qualifies, but unlike stocks and ETFs, it is not subject to the wash sale rule under current IRS guidelines. This allows investors to sell a digital asset at a loss and immediately repurchase it without losing the tax benefit. However, tax laws regarding cryptocurrency are evolving, so staying updated on IRS guidance is necessary.
Real estate investment trusts (REITs) and options contracts can also be used but come with complexities. REITs distribute taxable dividends, which cannot be offset by capital losses, and options contracts have different tax treatments depending on their classification.
The Rules for Offsetting Gains
Capital losses must first offset capital gains of the same type—short-term losses apply to short-term gains, while long-term losses offset long-term gains. This distinction matters because short-term gains are taxed at ordinary income rates (10% to 37% in 2024), while long-term gains receive lower rates (0%, 15%, or 20% based on income).
If capital losses exceed capital gains in a tax year, up to $3,000 of excess losses can be deducted against ordinary income ($1,500 for married individuals filing separately). Any remaining losses can be carried forward indefinitely.
Since short-term gains are taxed at higher rates, prioritizing short-term losses to offset them first can provide greater savings. If no short-term gains exist, losses then apply to long-term gains before being carried forward.
Identifying Specific Shares
Selecting which shares to sell when harvesting losses affects tax efficiency. Investors with multiple lots of the same security purchased at different times can specify which shares they are selling. Different accounting methods—First-In-First-Out (FIFO), Last-In-First-Out (LIFO), or Specific Identification—determine cost basis and realized loss or gain.
Specific Identification provides the most control, allowing investors to sell shares with the highest cost basis to maximize tax benefits. For example, if an investor bought shares at $50, $60, and $70 per share and the stock is now trading at $55, selling the $70 shares generates a larger loss than selling the $50 shares. To use this method, investors must notify their brokerage at the time of sale, as default settings often follow FIFO, which may not be optimal.
Brokerage platforms vary in cost basis reporting. Some offer automated tools to select the most advantageous shares for tax purposes, while others require manual selection. Investors should review their brokerage’s cost basis settings to ensure the correct method is applied. Failure to specify shares could result in smaller losses or even gains, negating the intended tax benefit.
Calculating Harvested Loss Amount
Determining the exact loss from a tax loss harvesting transaction requires calculating the adjusted cost basis and sale proceeds. The cost basis includes the original purchase price plus any transaction fees, while proceeds reflect the total amount received from the sale after brokerage commissions. The difference represents the realized capital loss.
For example, if an investor buys 100 shares at $40 per share with a $10 commission, the total cost basis is $4,010. If they later sell the shares at $30 each, receiving $3,000 before deducting a $10 selling commission, their total proceeds are $2,990. The realized loss in this case is $4,010 – $2,990 = $1,020.
Realized losses are recognized in the tax year when the trade is executed, not when funds are settled. This is particularly relevant at year-end when trades made in late December may settle in January, affecting when the loss can be claimed.
Wash Sale Considerations
A wash sale occurs when an investor sells a security at a loss and repurchases the same or a “substantially identical” security within 30 days before or after the sale. If triggered, the IRS disallows the loss for tax purposes and adds the disallowed amount to the cost basis of the repurchased shares.
The IRS does not explicitly define “substantially identical,” but it generally applies to the same stock, ETF, or mutual fund. Swapping one S&P 500 index fund for another from a different provider could be considered a wash sale, while replacing an individual stock with a similar company in the same industry would not. Investors using automated reinvestment plans, such as dividend reinvestment (DRIP), should also be cautious, as even a small reinvestment can trigger a wash sale.
Recordkeeping for Tax Reporting
Accurate records are necessary for correctly reporting tax loss harvesting transactions. Investors should track purchase dates, sale dates, cost basis, and proceeds for each transaction to ensure compliance with IRS regulations. Brokerages provide Form 1099-B, which reports capital gains and losses, but these forms may not always reflect specific share identification methods chosen by the investor. Keeping personal records helps verify accuracy and avoid discrepancies when filing taxes.
Tax software and spreadsheets can assist in organizing transactions, especially for frequent traders. Documentation should include trade confirmations, account statements, and any correspondence with the brokerage regarding cost basis elections. If losses are carried forward, maintaining a clear record ensures they are applied correctly in future tax filings.
Adjusting Basis After Sales
When a wash sale occurs, the disallowed loss is added to the cost basis of the repurchased security rather than being permanently lost. This increases the adjusted basis, which reduces future taxable gains when the new shares are eventually sold.
For example, if an investor sells 100 shares at $50 per share for a $1,000 loss and repurchases the same stock at $48 within the wash sale window, the disallowed loss is added to the new purchase price. Instead of a cost basis of $4,800, the adjusted basis becomes $5,800. This means future gains will be lower when the shares are eventually sold, effectively deferring the tax benefit rather than eliminating it.