Tax-Loss Harvesting Guide

What is Tax-Loss Harvesting?

Tax-loss harvesting is a strategy where you intentionally sell investments at a loss to offset capital gains and reduce your taxable income. It's one of the most powerful year-end tax planning strategies available to investors, potentially saving thousands in taxes annually while maintaining your investment strategy.

How Tax-Loss Harvesting Works

The Basic Mechanics

When you sell an investment for less than you paid for it, you realize a capital loss. This loss can be used to:

• First: Offset any capital gains from the same tax year
• Second: Offset up to $3,000 of ordinary income ($1,500 if married filing separately)
• Third: Carry forward remaining losses to future years indefinitely

Types of Capital Losses

Netting Rules

The IRS requires a specific order for matching gains and losses:

1. Net short-term: Short-term gains - short-term losses
2. Net long-term: Long-term gains - long-term losses
3. Net overall: If one is positive and one is negative, combine them
4. Apply to ordinary income: Remaining loss offsets up to $3,000 of wages, interest, etc.
5. Carry forward: Any excess loss moves to next year

The Wash Sale Rule: Critical to Understand

Wash Sale Triggers

A wash sale is triggered if you:

• Sell a stock at a loss and buy the same stock within 61-day window
• Sell a stock at a loss and your spouse buys it in their account
• Sell in a taxable account and buy in an IRA within 61 days
• Sell a mutual fund and buy an ETF that tracks the same index identically
• Have dividend reinvestment purchase shares during the window

What Happens to a Disallowed Loss?

The loss isn't lost forever—it's added to the cost basis of the replacement security:

• Example: You bought Stock A for $10,000, sold at $8,000 (loss: $2,000)
• Within 30 days, you bought Stock A again for $8,500
• The $2,000 loss is disallowed but added to your new purchase
• Your new cost basis becomes $10,500 ($8,500 + $2,000)
• You'll eventually get the tax benefit when you sell the replacement

Strategies to Avoid Wash Sales

Strategy 1: Wait 31 Days

The simplest approach:

• Sell the losing investment
• Wait 31 calendar days
• Repurchase the same investment
• Risk: Market may move against you during waiting period

Strategy 2: Buy Similar but Not Identical Securities

Maintain market exposure with different investments:

Strategy 3: Double Up Then Sell

If you want to harvest losses but don't want to be out of the market:

1. Buy an equal amount of the investment you want to sell
2. Wait 31 days
3. Sell the original shares at a loss
4. You now own the shares continuously without triggering wash sale
5. Downside: Requires double the capital for 31 days

Year-End Tax-Loss Harvesting Process

Step 1: Review Your Tax Situation

• Calculate realized capital gains for the year
• Identify short-term vs long-term gains
• Estimate your marginal tax rate
• Determine how much loss harvesting would benefit you

Step 2: Analyze Your Portfolio

Look for positions with unrealized losses:

• Review cost basis vs current value for each holding
• Prioritize short-term losses (more valuable)
• Consider the magnitude of each loss
• Evaluate whether you still want to own the investment long-term

Step 3: Calculate Potential Tax Savings

Step 4: Execute the Harvest

• Place sell orders for positions with losses
• Immediately buy replacement securities (if using swap strategy)
• Document the trades and reasons for your records
• Update your tracking spreadsheet
• Set calendar reminders for 31 days if planning to repurchase

Step 5: Track and Document

• Keep records of all harvested losses
• Track wash sale windows in a calendar
• Document which securities replaced which
• Note carried-forward losses for future years
• Save brokerage confirmations

Advanced Tax-Loss Harvesting Strategies

Direct Indexing

Instead of owning an S&P 500 index fund, own all 500 stocks individually:

• Allows harvesting losses on individual stocks while maintaining S&P 500 exposure
• Can harvest losses throughout the year, not just year-end
• Typically requires $100,000+ to implement effectively
• Higher complexity and trading costs
• Many robo-advisors offer this automatically

Tax Alpha

The additional return generated through tax-efficient strategies:

• Consistent tax-loss harvesting can add 0.5-1.5% annually to after-tax returns
• Compounded over decades, this significantly improves wealth accumulation
• Most valuable in high tax brackets
• Benefits increase with portfolio size and volatility

Qualified Small Business Stock (QSBS)

Special consideration for startup equity:

• Up to $10 million in QSBS gains can be excluded from federal taxes
• Harvested losses cannot be used to offset QSBS gains
• Strategy: Save harvested losses for other gains, let QSBS use exclusion

Common Mistakes to Avoid

Year-End Timing Considerations

Critical Deadlines

• Trade date, not settlement: Must execute by December 31, even if settles in January
• Market hours: December 31 is often a half trading day
• Wash sale window: Extends into January, so avoid repurchasing until February
• December volatility: Markets can move significantly at year-end

Optimal Timing Strategy

• October-November: Review portfolio, identify losses, plan strategy
• Early December: Execute primary harvesting trades
• Mid-December: Monitor for additional opportunities
• Late December: Final adjustments only if necessary
• Early February: Repurchase if using wait strategy

When NOT to Harvest Losses

Tax-loss harvesting isn't always beneficial:

• Low or zero tax bracket: Little benefit if you pay no capital gains tax
• Expect lower future tax rates: Better to take gains now, losses later
• No current or expected gains: Limited immediate benefit (though can offset income)
• Truly want to exit position: If investment thesis has changed permanently
• High transaction costs: Fees and bid-ask spreads exceed tax benefit
• Very small positions: Administrative burden exceeds value

Tax-Loss Harvesting Checklist

Working with Tax Professionals

Tax-loss harvesting can get complex. Consider professional help if:

• You have large portfolios with many holdings
• You trade frequently and have complex gain/loss situations
• You have state-specific tax considerations
• You own alternative investments (real estate, partnerships, etc.)
• You're subject to AMT (Alternative Minimum Tax)
• You have foreign investments with currency considerations