What Is the Tax Loss Harvesting Limit?

Tax-loss harvesting is an investment strategy that involves selling investments at a loss to offset capital gains, which are profits from selling assets like stocks or bonds. By realizing losses, an investor can lower the total taxes owed on their investment profits for the year, managing a portfolio’s tax efficiency.

The Capital Loss Netting Process

The Internal Revenue Service (IRS) requires a specific netting process before losses can reduce other income. This involves categorizing capital gains and losses as either short-term (assets held one year or less) or long-term (assets held more than one year). This distinction is because short-term gains are taxed at higher, ordinary income rates.

The first step is to net losses against gains of the same type. Short-term capital losses are used to offset short-term capital gains, and long-term capital losses offset long-term capital gains. This initial matching ensures losses are first applied against similarly taxed gains.

If a net loss remains in one category, it is then used to offset a net gain in the other. For instance, a $10,000 net short-term loss would be used to completely offset an $8,000 net long-term gain. The investor would be left with a remaining net short-term capital loss of $2,000. This cross-category netting is required before any remaining loss can be deducted.

The Annual Deduction Limit

If an investor has a remaining net capital loss after the netting process, there is a limit on the amount that can be deducted against other income. The IRS sets this annual limit at $3,000 for most filers ($1,500 for those married filing separately). This deduction reduces ordinary income, which includes sources like wages and salaries.

This deduction is only available after all capital gains for the tax year have been fully offset by capital losses. For example, if an investor has $5,000 in capital gains and $12,000 in capital losses, the first $5,000 of losses must neutralize the gains. The remaining $7,000 net capital loss can then be used to deduct $3,000 from ordinary income.

The $3,000 figure is a ceiling on the deduction against ordinary income, not a limit on the amount of losses that can be realized. Investors can realize losses far exceeding this amount. The primary function of losses is to first offset gains, with the deduction against ordinary income serving as a secondary benefit.

The Wash Sale Rule

The wash sale rule restricts tax-loss harvesting by preventing an investor from claiming a loss on a sale. This rule, detailed in IRS Publication 550, is triggered by selling a security at a loss and acquiring a “substantially identical” one within a 61-day period (30 days before, the day of, and 30 days after the sale). The regulation stops investors from claiming a tax deduction while maintaining their investment position.

The IRS does not explicitly define “substantially identical,” but it is understood to include shares of the same company’s stock, as well as certain options or warrants. A common strategy to avoid this rule is to reinvest proceeds into a security that tracks a similar but not identical index, maintaining market exposure.

If a wash sale occurs, the loss is disallowed for that tax year. The disallowed loss amount is added to the cost basis of the newly acquired, substantially identical security. This adjustment defers the tax benefit until the replacement security is sold. For instance, a disallowed $1,000 loss is added to the cost basis of the new shares.

Handling Excess Losses

When net capital losses exceed the annual $3,000 deduction limit, the unused portion is not forfeited. Instead, these excess losses can be carried forward to subsequent tax years. This provision allows investors to use the losses to offset future capital gains or deduct from ordinary income.

Losses that are carried forward retain their original character as either short-term or long-term. When used in a future year, they must be applied according to the same netting rules, with short-term carryovers applied against short-term gains first.

This carryover process continues indefinitely until the full loss is used. Each year, the investor first uses carryover losses to offset any capital gains. If a loss still remains, the investor can deduct up to $3,000 against ordinary income and carry the rest forward.