Tax Loss Harvesting: A Guide to Cutting Your Tax Bill

When you invest your money, you hope the value of your investment will rise and you’ll make money. Unfortunately, any investment involves some element of risk, and some investments lose money.

There’s a silver lining if you pick a few duds: tax loss harvesting can help you turn investment losses into tax wins.

What Is Tax Loss Harvesting?

Tax loss harvesting is a strategy investors use to reduce their taxable income by selling securities at a loss and using that loss to offset capital gains earned during the year.

This strategy is particularly useful if you make profitable investments but also hold investments that have declined in value. By selling the underperforming investments, you can use the losses to counterbalance the gains, reducing your overall taxable income for the year.

Tax loss harvesting can be a powerful tool for minimizing your tax bill, but you need to understand the rules and guidelines to apply this strategy effectively. The tax code includes some fine print that can trip you up if you’re unaware.

How Tax Loss Harvesting Works

When you sell an investment at a loss, that loss can be used to offset gains you’ve realized from selling other assets. There are two types of capital gains:

1. Short-term capital gains apply to assets you’ve owned for one year or less. They’re taxed as ordinary income, so your income tax rate could range from 10% to 37%, depending on your taxable income.

2. Long-term capital gains apply to assets you’ve owned for more than a year. They have lower tax rates—typically 0%, 15%, or 20%, depending on your total taxable income bracket.

Tax loss harvesting involves applying realized losses to offset gains of the same type (short-term or long-term). Once you net capital gains of the same type, you can use any excess losses to offset the other kind of gain.

Plus, if your total capital losses exceed your total capital gains for the year, you can deduct up to $3,000 ($1,500 if married filing separately) of the remaining loss against your ordinary income. Any unused losses can be carried forward to a future tax year.

Tax Loss Harvesting Rules

Tax loss harvesting is a legal and effective strategy for reducing your taxable income, but you need to understand and follow a few rules to avoid penalties or disallowed deductions.

Calculating Basis

You need to know your basis to calculate your potential gains and losses. Your basis in an investment is the price you paid for it plus any associated transaction costs such as commissions or fees. This is referred to as your initial basis. Over time, your basis may go up or down as you reinvest dividends or receive capital gains distributions, which increase your basis, or returns of capital, which decrease it.

The difference between your basis and the asset’s sale price determines the gain or loss.

For example, if you bought shares of Coca-Cola stock for $5,000 and later sold them for $3,000, you would realize a $2,000 capital loss.

Avoiding the Wash Sale Rule

The wash sale rule prohibits you from claiming a loss on a security if you repurchase the same or a “substantially identical” security within 30 days before or after the sale. If you do, you can’t use your loss. Instead, the disallowed loss increases your basis.

Essentially, the Internal Revenue Service (IRS) prevents investors from selling securities at a loss solely for tax purposes and then quickly rebuying them to maintain their investment positions.

For example, if you sell shares of Netflix at a $1,000 loss on December 15th and repurchase the same shares on January 5th for $2,000, the IRS won’t allow you to use the $1,000 loss to offset income from other stock sales. But your new basis in the stock you bought on January 5th is $3,000. That’s the $2,000 you paid for it, plus the $1,000 disallowed loss from the December 15th sale.

The rule applies not only to stocks but also to a mutual fund that’s considered substantially identical. It also applies across your entire portfolio—taxable and tax-advantaged accounts—even if you rely on investment advisors to handle them. So you can’t sell an investment in one account and buy it within the 61-day wash sale period.

Capital Gains and Losses in Taxable vs. Tax-Deferred Accounts

Tax loss harvesting is beneficial for taxable accounts (such as brokerage accounts) because the gains from these accounts are taxable. However, using tax loss harvesting in tax-deferred accounts like IRAs or 401(k) plans doesn’t make sense.

That’s because you can’t deduct losses in these accounts. In a tax-deferred account, any growth or losses are shielded from taxes until you make withdrawals—usually in retirement—so tax loss harvesting has no benefit.

Example of Tax Loss Harvesting

Let’s consider an example to see how tax loss harvesting works. Say your portfolio includes the following unrealized capital gains:

· Shares of Apple with a $50,000 long-term capital gain

· Shares of Exxon Mobile with a $30,000 long-term capital loss

· Shares of Toyota with a $10,000 short-term capital gain

· Shares of T-Mobile with a $12,000 short-term capital loss

You sell the shares of Apple and Toyota, generating $50,000 in long-term gains and $10,000 in short-term gains.

By selling the underperforming Exxon and T-Mobile stocks, you can use the losses to offset your gains. Then you have $20,000 in long-term capital gains and $2,000 in short-term capital losses.

Now, you can net capital gains. You reduce your long-term gain by your short-term loss, so you’ll only pay capital gains taxes on $18,000 in long-term capital gains.

Depending on your tax bracket, this could result in a significant reduction in your tax liability.

For example, say you pay 15% on long-term capital gains, and your ordinary income tax rate is 32%. If you didn’t take advantage of the tax loss harvesting strategy, you’d pay roughly $11,340 in capital gains taxes from selling Apple and Toyota stock. That’s $7,500 on the long-term capital gains plus $3,840 in short-term capital gains.

But tax loss harvesting means you’ll pay only $2,700 in capital gains tax. That’s a savings of $8,640. Depending on your income, tax loss harvesting might also allow you to avoid the net investment income tax (NIIT). NIIT is a 3.8% tax rate that applies to investment income when your modified adjusted gross income exceeds $200,000 for single filers, $250,000 for married filing jointly, or $125,000 for married filing separately.

Should You Use Tax Loss Harvesting for Tax Savings?

Tax loss harvesting can be a valuable way to turn losing money into a tax break, but it can get complicated, especially when dealing with large portfolios or complex investments. That’s why it’s a good idea to work with an advisor to ensure you follow the tax rules and optimize your investment strategy.

To help understand how tax loss harvesting works and how to apply it to your capital assets, schedule a free consultation with PaulHood. We can help you strategically lower your federal income tax bill and save money.