What is Tax-Loss Harvesting?
Tax-loss harvesting is an investment strategy that involves selling securities that have declined in value to realize a capital loss. This loss can then be used to offset capital gains, reducing tax liability. The sold position is typically replaced with a similar investment to maintain market exposure.
How Tax-Loss Harvesting Works
Basic Process:
- Identify positions with unrealized losses
- Sell the losing position to realize the loss
- Purchase a similar (not identical) investment
- Use the loss to offset gains
Tax Benefits
Offsetting Gains:
- Short-term losses first offset short-term gains
- Long-term losses first offset long-term gains
- Remaining losses offset opposite type gains
Excess Losses:
- Up to $3,000 can offset ordinary income annually
- Unused losses carry forward indefinitely
Wash Sale Rule
Critical Compliance Issue: The IRS wash sale rule disallows a loss deduction if you purchase a "substantially identical" security within 30 days before or after the sale.
Wash Sale Considerations:
- Applies across all accounts (including IRAs and spouse accounts)
- 61-day window (30 days before and after)
- Requires careful replacement security selection
Replacement Investment Strategies
| Original Position | Acceptable Replacement |
|---|---|
| S&P 500 ETF (SPY) | Total Market ETF (VTI) |
| Individual stock | Sector ETF |
| Bond fund | Different duration/issuer fund |
| International ETF | Different index international ETF |
Implementation Considerations
When to Harvest:
- Year-end planning
- After significant market declines
- When rebalancing portfolios
- Before large expected gains
Costs to Consider:
- Trading costs
- Potential tracking error
- Administrative complexity
- Risk of wash sale violation
