Tax-Loss Harvesting Guide: Capitalize on Your Investment Losses
If you’re an investor with a taxable investment account, you should know about tax-loss harvesting. Tax-loss harvesting lets investors take advantage of market fluctuations to capture a tax loss on investments, offsetting future capital gains taxes.
Here’s a more detailed look at how tax-loss harvesting works, and how you can put it to use to save on taxes.
The Short Version
- Tax-loss harvesting is when you sell an investment at a loss and immediately re-buy a similar investment.
- This strategy locks in the investment loss for tax purposes.
- However, there are limits to this strategy, including how much you can claim and rebuying the same investment, known as the wash sale rule.
- You can harvest your tax-loss even on crypto and NFTs — but there are unique strings attached
What Is Tax-Loss Harvesting?
Tax-loss harvesting is an investment strategy of selling investments at a loss and immediately re-buying a similar investment to lock in an investment loss for tax purposes. After tax-loss harvesting transitions, your portfolio should have a nearly identical allocation. The only cost, if any, is transaction fees.
However, depending on your income and tax situation, you could wind up significantly better off when taxes are due. When you have a realized gain in the future in a taxable account, you'll be glad you used the tax-loss harvesting strategy.
Tax-loss harvesting doesn’t mean you’ve made bad investments or will lose in the long term. Even highly successful investors like Warren Buffett see ups and downs in their portfolios over time. Employing tax-loss harvesting techniques may help you lower your tax bill when you sell with a capital gain.
Example of Tax-Loss Harvesting
Let’s say you buy $10,000 of the iShares Core S&P 500 exchange-traded fund (ETF) and look back at your portfolio a year and a half later and see it is now worth $8,000. You think the market is still going up in the long run and want to keep the investment. That’s where your tax-loss harvesting comes in.
You can sell the index fund and quickly buy another broad market index fund — say, the Vanguard Total Stock Market Index Fund ETF, which follows the same index and charges the same fees. Once the sale is final, you can claim $2,000 in long-term tax losses and are essentially in the same position as you started.
Related >>> How to Invest in the S&P 500 Index
When Could Harvesting Losses Make Sense?
Tax-loss harvesting transactions can take place at any time. If your portfolio is in a position where you’re holding an investment at a loss, you may be able to employ tax-loss harvesting. Any sale must be completed by the end of the tax year (Dec. 31) to be eligible to use this loss harvest technique to offset a capital gain.
Harvesting tax losses works best when holding a diverse portfolio of index funds with comparable alternatives available. You may have a more challenging time finding similar alternative investments.
Gains are taxable and losses derived from tax-loss harvesting may offset capital gains. If you sold investments for a $3,000 profit and had $1,000 of tax losses from harvesting transactions, you would pay taxes as if you had made $2,000. If your losses are more than your gains, you may carry those losses over to the next year in most cases.
When Does Tax-Loss Harvesting Not Make Sense?
There are three main cases where tax-loss harvesting doesn’t make sense and won’t save you money:
You Have No Realized Capital Gains for the Current Tax Year
Sometimes it’s easy to forget that your capital gains are $0 until you actually sell an appreciated asset. So even if your net worth soared in any given year, you have $0 in realized profits or losses until you make a sale. No capital gains = no capital gains taxes.
Learn more >>> Long-Term vs. Short-Term Capital Gains Tax
Your Taxable Income Qualifies You for the 0% Capital Gains Tax Bracket
Your capital gains tax bracket is 0% until you hit $41,676 in income, at which point it rises to 15%. At $459,751, it rises to 20%.
So if your taxable income sits at or below $41,675 for an individual filing (or $83,350 if you’re filing jointly with a spouse), you don’t owe a penny in capital gains taxes (with some exceptions).
You Took a Loss in a Retirement Account With Tax-Free Distributions
Finally, tax-loss harvesting really only makes sense inside taxable investment accounts, since you’re trying to reduce your current year tax burden for your capital gains.
But if you withdrew your post-tax contributions to a Roth IRA, for example, you don’t have to worry about capital gains taxes (just penalties).
Can You Harvest Your Losses From Crypto?
Short answer: yes.
The IRS considers crypto to be a taxable asset just like property and stocks. And that’s not a recent development, either; the agency issued Notice 2014-21 all the way back in 2014, signaling to the crypto world that “Hey – we know what you’re doing and it’s time to pay the piper.”
The silver lining to crypto being taxable, however, is that you can now leverage your crypto portfolio for tax-loss harvesting.
For example, let’s say that you shorted Carvana stock, closed out your position, and realized a capital gain of $5,000.
At the same time, you have some Bitcoin that you bought at $10,000 that’s now worth $6,000.
- If you do nothing, you’ll have $5,000 of taxable capital gains.
- If you sell your Bitcoin for $6,000 and harvest the $4,000 loss, you’ll shrink your taxable capital gains from $5,000 to just $1,000.
Now, the wash sale rule would imply that you can’t buy more Bitcoin with that $6,000 for at least 30 days.
Or does it?
At Present, Crypto Is Not Subject to the Wash Sale Rule
According to Notice 2014-21, the IRS classifies crypto as property — not a security.
That’s a key difference because per Publication 550, the wash sale rule only applies to the latter.
This means that for now, crypto is not subject to the wash sale rule. Technically speaking, there’s nothing in the IRS rulebook stopping you from selling and repurchasing the same crypto asset within 30 days – or even 30 minutes – and harvesting the capital loss.
Granted, a lot can happen in a few minutes in the crypto world, so there’s still risk involved in a quick flip (even for the same asset). Plus, some say the IRS is aware of the loophole and are working to close it for tax year 2023.
But for now, tax-loss harvesting might be considered easier for crypto than for stocks, considering there’s no waiting period and no need to seek out a similar asset.
Can You Harvest Your Losses From NFTs?
On paper, yes.
Like crypto, the IRS considers NFTs and other digital assets to be property. Therefore, gains/profits can be taxed and losses can be harvested. You can even donate them for a write-off of their current market value.
That said, 100% losses due to theft or rug pull scams can’t be harvested, since NFTs aren’t listed as eligible deductions in The Tax Cuts and Jobs Act of 2017.
The only way to tax-loss harvest an NFT sale is to do an “arm’s length transaction,” meaning you sell it to someone you don’t know for a fair market price.
Conversely, if you sell it to yourself on OpenSea for 0.0001 ETH and harvest the loss (don't do this) – and the IRS finds your illicit trade on the blockchain (which they’ve been known to do) – you could face legal consequences.
Can You Harvest Your Tax Losses To Reduce Your Regular Income Tax?
If you bought and sold an asset for profit within the span of a year, the IRS treats that as a short-term gain and taxes it at your regular income tax rate — not your capital gains tax rate.
For example, let’s say you make $400,000 a year. For tax year 2022, that qualifies you for the 35% income tax bracket and the 15% capital gains tax bracket.
Say you sell Microsoft (MSFT) at a $5,000 profit.
- If you did it within one year, your gains will be taxed at 35%
- If you waited a year, your gains will be taxed at 15%
It’s a $1,000 cash difference, and definitely one worth paying attention to.
Naturally, the easiest thing to do would be to wait so your gains are taxed at a 20% lower rate. But sometimes, it’s just the right time to sell.
So here’s how you could lower short-term capital gains tax liability for the current tax year:
If you sell a different asset at a loss of $10,000, you’ll offset all $5,000 of your short-term capital gains from your sale of MSFT. Looking at the remaining $5,000, you could offset $3,000 from your regular income and carry the $2,000 forward to offset even more income in future tax years.
If that’s all starting to sound a little complicated, well, that’s why most folks let a professional or a robot do tax loss harvesting for them.
But in short, yes, you can defer thousands in income tax by careful tax-loss harvesting of short term capital gains.
Related >>> 9 Ways to Reduce Your Taxable Income in 2023
Can Harvesting Losses Improve Your Investment Returns?
Tax-loss harvesting shouldn’t have a meaningful influence on your investment results. Your gains and losses will ultimately be similar either way. The big difference is noticeable on your tax return.
If you can save $500 per year on taxes due to tax-loss harvesting, that can quickly add up to tens of thousands of dollars in savings over the years — worth much more if you keep those savings in a well-performing investment account.
So, while tax-loss harvesting may not improve your investment results, it will improve how much money you have to keep after taxes. Depending on how you look at it, you could argue that better net results improve your investment results, but it won’t make stock prices go any higher.
Limitations to Tax-Loss Harvesting
By now, maybe you're scheming that you can sell and repurchase your entire investment portfolio when it’s down to offset capital gains. However, according to IRS rules, you can’t sell and repurchase the same investment within 30 days and claim the tax loss.
These are the most important limitations to know about when dealing with tax-loss harvesting:
- Wash sale rule: The wash sale rule says you can’t sell and rebuy the same or “substantially identical” investment. Take this rule in mind when swapping for a different mutual fund. Find out more in our Wash Sale Rule Guide.
- Annual limits: Tax losses may only be claimed up to a specific limit, depending on your tax filing status. The maximum limit is $3,000 per year or $1,500 per individual for married couples filing separately.
- Short-term and long-term matching: A short-term loss offsets short-term capital gains, and the same goes for long-term gains. You may have to use your long-term capital gain balance first if you’re coming into a situation with capital loss carryovers. Remember, short-term gains are taxed as ordinary income. That's often at a higher tax rate.
The Bottom Line
Tax-loss harvesting isn't necessary in a retirement account where you don’t pay any taxes until you withdraw from the account. This strategy is best with taxable investment accounts. If you have this kind of account, particularly with a fund-based strategy, you’re in an excellent position to take advantage of tax-loss harvesting, which can be a huge tax benefit.
If selling and buying stocks and funds seems intimidating, consider a tax-loss harvesting strategy with a robo advisor that includes automatic tax-loss harvesting. This is one service that could automatically save you thousands of dollars for years to come.
And if you're looking for personal tax advice, consider working with a trusted financial advisor or another tax professional. You don't want to accidentally wind up with tax penalties or pay too high of a tax bill for your investment income.
The IRS description that is appropriate for securities that are subject to wash sale restrictions is “substantially identical,” not “substantially similar.” That is an important distinction to maintain. If an investor is generally happy with his existing allocation, he is allowed to sell a security at a loss and replace it with something similar, but not “substantially identical,” and still be able to take advantage of the tax loss.