Tax-Loss Harvesting
Tax-loss harvesting is an investment strategy that realizes capital losses to offset capital gains, reducing taxable income. It requires careful attention to wash-sale rules under IRC § 1091.
Definition
Tax-Loss Harvesting —
Tax-loss harvesting is the practice of selling a security at a loss to realize a capital loss that can offset capital gains elsewhere in the portfolio, reducing taxable income. The harvested loss can offset an equivalent amount of capital gains; losses exceeding gains can offset up to $3,000 of ordinary income per year, with excess losses carried forward to future tax years. The strategy is subject to the wash-sale rule under IRC § 1091, which disallows the loss if a substantially identical security is repurchased within 30 days before or after the sale.
How tax-loss harvesting works
Step 1: Identify a position with an unrealized capital loss.
Step 2: Sell the position to realize the loss. The loss is now a "harvested" capital loss that can be used to offset capital gains.
Step 3: Reinvest the proceeds in a similar (but not substantially identical) security to maintain market exposure and avoid disrupting the portfolio strategy.
Step 4: Apply the harvested loss against capital gains on the tax return. Net losses above $3,000 carry forward.
The wash-sale rule (IRC § 1091)
The IRS wash-sale rule disallows a capital loss if the taxpayer purchases a "substantially identical" security within the 30-day window before or after the sale. The disallowed loss is not permanently lost — it's added to the basis of the repurchased security — but the timing benefit is lost.
Key considerations:
- "Substantially identical" is not precisely defined in the Code but generally means the same security, same fund, or a fund tracking the same index
- Switching from one S&P 500 ETF to a different S&P 500 ETF from a different provider may be considered substantially identical
- Switching from a total market ETF to a large-cap ETF is generally not substantially identical
When tax-loss harvesting is most valuable
Tax-loss harvesting is most valuable when:
- The portfolio has realized or unrealized capital gains elsewhere that can be offset
- The portfolio holds positions with embedded losses (often after market declines)
- The investor is in a high marginal tax bracket (higher gains tax rate = more benefit from offsets)
- The investment time horizon is long (losses harvested now save taxes now, with the reinvested proceeds growing over time)
Tax-loss harvesting and AI research
AI research tools can help advisors identify candidates for tax-loss harvesting by scanning the portfolio for positions with unrealized losses that exceed a threshold, checking holding periods (to distinguish short-term from long-term losses), and suggesting replacement securities that maintain factor exposure while avoiding wash-sale concerns. The final decision requires advisor judgment and client-specific tax context.
Related
This glossary entry is general information, not tax advice. Consult a qualified tax professional for advice specific to your situation.
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