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What is Tax Loss Harvesting?

What is Tax Loss Harvesting?

April 12, 2024

Think of a farmer harvesting their crop after a full season’s grow. The crop isn’t consumed immediately after the harvest. Some of it may be consumed, however, most of it is stored and used in the future. The idea is similar with tax loss harvesting – sell investment’s that have performed subpar to realize a loss and use the loss to offset taxes that may be owed in the future on other investments that perform well. You are “harvesting” the loss to apply against potential capital gains or ordinary income taxes subject to Internal Revenue Code limitations. If a farmer misses planting season or has poor weather and a bad crop, they earn less income from their efforts or don’t make money at all. The same may be true for investors, missing opportunities to harvest losses may contribute to lower after-tax returns.

Over time, if your investments perform well, they grow in value, and you may eventually sell them to realize your profit. Once you realize your profits from a capital asset, there may be a tax due that is associated with the profit you’ve earned. In general, depending on how long you held your capital asset (e.g. investment), that gain may be taxed at long-term capital gains or short-term capital gains rates. Capital assets or similar investments held for one year or longer are taxed at long-term capital gains rates, either 0%,15%, 20%, 25%, or 28% depending on your income and type of asset. Investments held for one year or less and sold or exchanged for a gain are subject to short term capital gains tax treatment, which are generally taxed at ordinary income tax rates.

A common strategy financial professionals use is Tax Loss Harvesting. In general, this strategy realizes and recognizes losses in an investment portfolio intentionally to “harvest” the loss. The loss is then applied to offset ordinary income or capital gains taxes subject to Internal Revenue Code limitations. Here is an example:

I have a diversified portfolio of individual stocks that have performed well over the years. This year one of the stocks is in a loss position. My advisor recommends I sell the stock to realize the loss. I am flabbergasted, “Why in the world would I sell that when its down so much?! Isn’t this the time to buy more? Double down!”. “Well, you don’t have to stay out forever.” My advisor says. With tax loss harvesting you cannot purchase the investment 30 days before or after it is sold, the loss can be disallowed. Then he goes on to explain that by recognizing the loss I may be able to offset the amount of capital gains tax that I would otherwise owe on the investment property I was in the process of selling. Not to mention offsetting up to $3,000 of other income annually until the full loss is used up. Additionally, we were able to find an alternative replacement investment to reinvest the proceeds into that kept me invested and diversified. 

Here is a walkthrough of the scenario described above:

  • Diversified portfolio consists of 34 individual stock positions. (same principal may be applied to a portfolio with less holdings)
  • One of the positions is in a loss position.
  • Investment property being sold with a gain.
  • Sell stock position and reinvest in different stock or hold as cash and reinvest after 30 days.
  • Recognize the loss on sold stock position.
  • Offset capital gains tax from investment real estate sale to the extent of the loss recognized from stock sale. 
  • Offset up to $3k of ordinary income.
  • Carry forward unused capital loss to offset future capital gains or ordinary income, subject to IRC limitations.

All examples are provided for hypothetical purposes only.  Actual results will vary.  All investing involves risk including the potential loss of principal.  Please work with a tax and legal advisor for your specific situation.