Tax loss harvesting is one of those investment strategies that sounds complicated at first but is fairly straightforward at its core.
You sell an investment that has declined in value, realize the loss for tax purposes, and use that loss to offset capital gains elsewhere in your portfolio.
But there is more to tax loss harvesting than selling an investment at a loss before December 31.
When used thoughtfully, tax loss harvesting can help you manage capital gains, rebalance your portfolio, reduce the tax impact of selling appreciated investments, and create more flexibility in future years.
Here are some ways to think about tax loss harvesting beyond the basics.
1. Think beyond the $3,000 deduction
You may have heard that you can use up to $3,000 of capital losses against ordinary income each year.
That is true, but it is not necessarily the primary benefit of tax loss harvesting.
If your losses exceed your gains, you can generally deduct up to $3,000 of the remaining loss against ordinary income, with unused losses carried forward to future years.
For investors with substantial appreciated investments, the ability to offset gains can be much more valuable than simply generating a $3,000 deduction.
For example, imagine you have:
$30,000 of long term capital gains from selling an appreciated investment
$20,000 of unrealized losses elsewhere in your taxable portfolio
Realizing those losses could potentially reduce your taxable capital gain from $30,000 to $10,000.
That is a very different benefit than simply taking a $3,000 deduction.
2. Short term losses can be particularly valuable
Not all capital gains are taxed the same way.
Short term gains are generally taxed at ordinary income tax rates, while long term gains may qualify for lower capital gains tax rates.
This means the type of loss you harvest matters.
Short term capital losses can first offset short term capital gains. After the appropriate netting process, remaining losses can offset long term gains.
As a result, a short term loss can be especially useful when you have short term gains that would otherwise be taxed at higher ordinary income tax rates.
This is one reason it can be helpful to look at your entire tax picture before deciding which investments to sell.
3. Use tax loss harvesting as part of rebalancing
You do not necessarily need to sell an investment solely because it has a loss.
Instead, consider whether there is already a reason to sell or reduce the position.
Maybe one part of your portfolio has become too large. Maybe you want to move from an actively managed fund to a lower cost index fund. Maybe your investment strategy has changed.
If the investment is also sitting at an unrealized loss, that can create an opportunity.
You can sell the investment, realize the loss, and reinvest the proceeds into an appropriate replacement investment.
In other words, tax loss harvesting can sometimes allow you to make a portfolio change while reducing the tax consequences of doing so.
4. Be careful about what you buy next
This is where the wash sale rule becomes important.
Generally, if you sell an investment at a loss and purchase the same or a substantially identical investment within 30 days before or after the sale, the loss may be disallowed under the wash sale rules.
For example, suppose you own an S&P 500 index fund that has declined in value.
You sell it on December 15 to realize the loss, then buy the exact same fund again on December 20.
You may have created a wash sale, meaning you cannot currently use the loss as intended.
Instead, you might consider using a different investment that provides similar market exposure without being substantially identical.
This is one area where the details matter. You want your replacement investment to keep you appropriately invested while avoiding an unintended wash sale.
And remember that the wash sale rules can involve transactions outside the account where you realized the loss. A purchase in an IRA can create additional complications, so it is worth reviewing your transactions across accounts before harvesting a loss.
5. Look at your portfolio across all taxable accounts
Tax loss harvesting works best when you look at the bigger picture.
You might have investments spread across several brokerage accounts, a joint account, or an account held by a spouse.
Before selling anything, look at:
Unrealized gains and losses
Realized gains and losses already taken during the year
Short term versus long term gains and losses
Capital loss carryforwards from prior years
Upcoming purchases
Your expected taxable income
Your broader investment allocation
For example, if you already have $25,000 of realized capital gains this year, an investment sitting at a $10,000 unrealized loss may be much more valuable from a tax planning perspective than it would be in a year when you have no gains.
6. Your tax loss carryforward is an asset too
Suppose you harvest more losses than you can use in the current year.
That does not necessarily mean the strategy was unsuccessful.
Unused capital losses can generally be carried forward to future tax years.
This can become particularly valuable if you expect to sell a highly appreciated investment in the future.
For example, you might have a large stock position with a very low cost basis. You do not want to sell it today because you do not need the cash and the tax bill would be significant.
Meanwhile, you have accumulated $40,000 of capital loss carryforwards.
Those losses could potentially help offset some of the capital gain when you eventually sell the appreciated investment.
Tax planning is often about looking ahead, not just minimizing this year's tax bill.
7. Tax loss harvesting can work alongside gain harvesting
This may sound counterintuitive, but sometimes the goal is not simply to minimize capital gains.
There are situations where intentionally realizing a capital gain can make sense.
For example, taxpayers with relatively low taxable income may have room to realize long term capital gains at the 0% federal capital gains rate. The applicable thresholds depend on filing status and tax year.
This means a tax planning strategy might involve realizing some gains while also harvesting losses elsewhere.
The goal is to manage how much taxable income and capital gain you recognize, rather than automatically trying to make both numbers as low as possible.
This can be particularly relevant for retirees, people between jobs, early retirees, or anyone experiencing an unusually low income year.
8. Consider the Net Investment Income Tax
For higher income households, capital gains can also interact with the 3.8% Net Investment Income Tax, commonly called the NIIT.
The NIIT generally applies when modified adjusted gross income exceeds $200,000 for single filers or $250,000 for married couples filing jointly, subject to the specific rules for calculating the tax.
Because capital gains are generally included in net investment income, reducing net capital gains through legitimate tax loss harvesting may also reduce the amount of investment income subject to the NIIT.
This is another reason the value of a harvested loss can extend beyond the capital gains tax rate you see at first glance.
9. Do not let the tax tail wag the investment dog
There is an important caveat to all of this.
A tax benefit should not be the only reason you make an investment decision.
If you sell an investment simply to generate a tax loss but then replace it with an investment that does not fit your portfolio, risk tolerance, or long term strategy, you may be solving a tax problem while creating an investment problem.
The same is true if you hold an investment you no longer want simply because selling it would create a gain.
Taxes are an important part of investment planning, but they are only one part.
The goal is not to avoid taxes at all costs. The goal is to make investment decisions that are appropriate for your overall financial plan while being thoughtful about when and how taxable gains and losses are recognized.
A year end tax loss harvesting checklist
Before the end of the year, consider reviewing:
What gains have already been realized this year?
What investments currently have unrealized losses?
Are those losses short term or long term?
Do you have capital loss carryforwards from previous years?
Are there investments you already wanted to sell or replace?
What will you purchase after selling the investment?
Could the transaction create a wash sale?
Are you expecting a large capital gain in the future?
What does your projected taxable income look like?
Could the Net Investment Income Tax apply?
Tax loss harvesting can be a useful tool, but the biggest opportunities often come from coordinating it with the rest of your financial plan.
Instead of asking, “What can I sell at a loss before December 31?” consider asking, “How can I manage my portfolio and taxable income more strategically over the next several years?”
That broader perspective is where tax loss harvesting becomes much more than a year end tax trick.
Disclaimer: This article is for informational purposes only and should not be considered individualized financial, tax, or legal advice. Tax rules can change, and individual circumstances vary. Consult with your financial planner and tax professional before implementing tax planning strategies.
