Entering the fourth quarter and approaching the end of the year, investors begin to prepare for the upcoming tax season. Part of that preparation is assessing the performance of your holdings over the past year. You may wish to examine if any of your stock or fund holdings are below their purchase price before year-end. Did you sell any assets for realized gains or losses? Depending on your tax bracket and the length of time the assets were held, any gains are subject to taxation as either short-term or long-term capital gains. However, losses can be used to offset gains and lessen your tax liability.

Tax-loss harvesting is the use of realized losses to offset realized gains, lowering taxes for the current year and potentially future years, too. This can be done in taxable investment accounts only. You cannot use losses on assets held in a traditional individual retirement account (IRA), a 401(k) account or other tax-deferred accounts to offset gains, since capital gains and losses in these retirement accounts are not taxed.

Many investors reinvest in the asset sold after harvesting its losses. When reinvesting the cash received from the harvested asset, it is important to avoid wash-sale rules that disallow the use of capital losses to offset gains.

How It Works

As an example, say you invested $100,000 in an exchange-traded fund (ETF) that faced a decline, bringing the value of your investment down to $75,000. If you sold your ETF shares at their lower price, you would realize a loss of $25,000, which you can apply as a deduction to your income taxes to offset any capital gains you realized in the same year through the sale of appreciated assets.

If you have more losses than gains, you can apply up to $3,000 of your capital losses against your regular income as a deduction in any given year. Any capital losses remaining after the deduction are carried over indefinitely into future years. Each year, you apply the losses carried forward against capital gains, and then use any remainder (up to $3,000) to reduce regular income.

If you have more gains than losses, the realized $25,000 loss reduces the gains to be taxed. So, if you realized gains of $50,000 from the sale of shares in another ETF holding, only half of those gains would be subject to taxation ($50,000 – $25,000). If your shares were held for less than one year, the $50,000 in gains would be taxed as short-term capital gains and included in your regular income; if held for more than one year, the gains would be taxed at the lower long-term capital gains rate.

Capital losses can be used to offset both short-term and long-term gains. However, losses must first be used to offset like gains—i.e., short-term losses offset short-term gains and long-term losses offset long-term gains. If you sold a long-term investment at a $25,000 loss but only had $10,000 in long-term gains for the year, you could apply the remaining $15,000 to any short-term gains.

Avoiding Wash-Sale Rules

The Internal Revenue Service (IRS) understands that investors can favorably time the sale of their investments and that realized capital losses reduce the taxes investors will pay. Aware of all this, the IRS disallows wash sales, which occur when substantially identical investments are purchased shortly before or after the sale of an asset for a realized capital loss.

However, using the previous example, the investor can harvest their tax losses by selling their loss position and immediately replacing their sold asset by reinvesting the $75,000 of generated cash in similar, but not substantially identical, holdings without triggering the wash-sale rules.

The wash-sale rules disallow the loss on the sale of an asset when a substantially identical asset is acquired within a 30-day period following the initial sale. This also applies to a substantially identical asset acquired within a 30-day period before the sale. The portion of the loss disallowed depends upon the number of shares acquired compared to the number of shares sold. If 50% of the shares sold were acquired within the restricted time period, 50% of the loss would be disallowed.

So the investor can wait out the 30-day period before reinvesting or can instead invest in a similar but different asset. The latter option is easier to accomplish with funds—especially with index ETFs, which have similar objectives and tend to have similar performance if they are using the same benchmark.

Other Prohibitions

As mentioned before, tax-loss harvesting is only an advantage of taxable investment accounts.

Additionally, capital losses cannot be used to offset income from qualified dividends, even though they are taxed at the same rate as long-term capital gains.

Investors are also prohibited from using capital losses to offset income from conversions of money moved out of traditional IRAs into Roth IRAs and income from required minimum distributions (RMDs).

When Not to Harvest Losses

The efficacy of tax-loss harvesting is ultimately based on your tax situation and which tax bracket applies to your income. Realizing a capital loss allows you to offset capital gains that would be taxed at your capital gains rate or offset income that would be taxed at your marginal income tax rate. Potentially, both.

If your capital gains tax rate is 0%, the harvested tax loss is an outright loss: There is no benefit to offsetting capital gains that are not taxed anyway. In this scenario, it may not be worth realizing a capital loss and subsequently reinvesting at perhaps a lower asset value. If you expect to be in a higher capital gains tax bracket later when you sell these shares, you may wish you had not lowered your investment’s cost basis.

Offsetting short-term gains with short-term losses normally provides a bigger benefit than offsetting long-term gains for tax-loss harvesting purposes. This is because short-term losses are first applied against short-term gains, which are normally taxed at higher marginal tax rates.

Conclusion

Tax-loss harvesting has three main benefits: Tax losses represent an opportunity to defer capital gains taxes; tax losses can be used to deduct $3,000 from your regular income taxes each year after offsetting realized gains; and any remaining losses are rolled over into the subsequent years.

Keep in mind that these benefits only apply to assets in taxable investment accounts and do not apply to tax-preferred accounts, such as traditional and Roth IRAs. It is also important to avoid triggering wash-sale rules by waiting out the 30-day period or purchasing a similar but different asset.

Based on your tax situation, tax-loss harvesting may be an effective strategy to reduce your tax liability each year. It does not matter whether the gains and losses are a mixture of short- and long-term—a capital loss can be used to offset a capital gain.