How Does Tax-Loss Harvesting Work—and Is It for You?

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If you have a portfolio and have sold any stocks at a profit this year, you might be looking for a way to offset the capital gains tax. That’s where tax-loss harvesting comes into play. It’s a way of selling investments that helps you lessen the capital gains tax blow.

But what is tax-loss harvesting, and when should you use it as a financial strategy?

Tax-Loss Harvesting Method of Selling Investments

Sometimes a losing investment can work out well for you. Tax-loss harvesting is when you sell that losing investment. Once you sell it, you use the loss to offset some of your capital gains.

But then, with the funds you have from the sale, you reinvest. It’s a straightforward strategy. But you do need to know the nuances to avoid some pitfalls.

Dumping a Losing Stock

The positive difference between the cost bases—what an individual paid for the investment—and what they later sell it for is a capital gain. If it is a negative difference, it’s a capital loss. So when you see that you have a negative difference, you might want to cut bait and pull your line in. That’s where this IRS-approved strategy works.

With the tax-loss harvesting, you are permitted to deduct up to $3,000, in one year, of your capital loss. This would come in handy if you made a capital gain earlier.

For example, if you sold stock and had a capital gain of $5,000, you would be required to pay taxes on that $5,000. But if you took advantage of the tax-loss harvesting, you could sell a stock that’s not performing and take the loss. You then would deduct the loss, using up to $3,000 to offset some of the $5,000 gain you made earlier. And although you can only deduct $3,000 in one year, you can take the additional loss deduction in future years if your loss exceeds $3,000.

An investor could also use the capital loss to offset personal income. This loss can also be carried over into future years to offset other gains.

Know the Wash Sale Rule

The wash sale rule prohibits repurchasing the same stock you just sold for tax-loss harvesting. You cannot buy identical stock or “substantially identical” stock or security within a 60-day window of selling the tax-loss harvest stock. The 60-day window is 30 days before and 30 days after the sale.

An individual cannot offset gains with a wash sale transaction. This goes for married couples, too. One spouse cannot repurchase the same stock the other spouse sold. That would come under the wash sale rule. You also can’t sell a stock on one platform and then purchase it on another. So, don’t sell a stock, then turn around and try to purchase it for your IRA. Again, that comes under the wash sale rule.

If the wash sale rule is abused, regulators can subject you to fines or restrict your trading.

The wash sale rule doesn’t apply to cryptocurrency. The IRS considers crypto a property rather than a security. But an investor can sell cryptocurrency at a loss and use the tax-loss harvesting strategy.

Period to Tax-Loss Harvest

Most investors wait until the end of the year to tax-loss harvest. It gives them a better idea of their financial circumstances.

But be aware of any stock dividends the investment you’re selling could have. If you sell stock before the ex-dividend date, you will be selling your right to the dividend.

Reasons for Tax-Loss Harvesting

If you have investments subject to capital gains tax, tax-loss harvesting could lower your tax burden. This is the number-one reason people use tax-loss harvesting.

Also, if you think you will be moving to a higher tax bracket this tax year, tax-loss harvesting could be a way to defer some capital gains. Remember, you can carry the loss over to future years. For example, you could apply the loss to future increases in income.

Even if you had a bad investment year, you still may want to take advantage of tax-loss harvesting. You can use the strategy to offset other income. This will lower your taxes.

Although you want to avoid the wash sale rule, tax-loss harvesting encourages you to rebalance your portfolio.

Deferring taxes until future years with tax-loss harvesting only works if conditions remain the same. But the financial world and taxes change.

A small investor may not have the large or frequent capital gains that make tax-loss harvesting worth it. Also, if you’re not in it for the long haul, tax-loss harvesting may not be for you. This is a long-term investment strategy.

If you can’t find a suitable replacement for the stock you are selling, you may not want to sell it just to take advantage of tax loss harvesting. The dividends and potential of the stock may outweigh any tax benefits.

If you have a tax deferred retirement account tax harvesting is not effective. Losses can’t be deducted in a tax deferred account. That is because the accounts are already receiving favorable tax treatment.

Is Tax-Loss Harvesting the Right Move?

No one likes to pay capital gains taxes. Tax-loss harvesting may be a way to defer some of these taxes. But it’s not for everyone.

Consult your financial advisor and evaluate whether tax-loss harvesting is an appropriate strategy for your portfolio and financial goals.

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