Strategies for Harvesting Tax Losses

Quick answer

• Tax-loss harvesting involves selling investments that have lost value to offset capital gains and, potentially, ordinary income.
• It’s a strategy to reduce your tax bill, not necessarily to improve investment performance directly.
• You can use realized losses to offset an equal amount of ordinary income each year, up to a limit.
• Be aware of the wash-sale rule, which prevents you from immediately repurchasing the same or a substantially identical security.
• This strategy is most effective when you have taxable investment accounts, not tax-advantaged retirement accounts.
• Consult a tax professional to ensure you’re implementing tax-loss harvesting correctly within your specific financial situation.

What to check first (before you file or change withholding)

Before diving into tax-loss harvesting, it’s crucial to understand your current tax and financial landscape. This preparation ensures you’re making informed decisions and not creating new problems.

Filing Status

Your filing status (Single, Married Filing Jointly, Married Filing Separately, Head of Household, Qualifying Widow(er)) significantly impacts your tax brackets, standard deduction, and eligibility for certain credits and deductions. Ensure you are using the most advantageous and accurate filing status for your situation.

Income Sources

Identify all sources of income, including wages, salaries, self-employment income, interest, dividends, capital gains, and any other earnings. Understanding the total amount and types of income is essential for calculating your tax liability and determining how much of your capital losses can offset ordinary income.

Withholding or Estimated Payments

Review your current tax withholding from your paycheck (W-4 form) or your estimated tax payments for the year. If you’ve been over-withholding, you might have more cash flow now but could have been using that money throughout the year. If you’ve been under-withholding, you might face a tax bill. Adjusting withholding can help you better align your tax payments with your actual liability, potentially freeing up cash that could otherwise be used for tax-loss harvesting.

Deductions and Credits

Familiarize yourself with the deductions and credits you are eligible for. These can significantly reduce your taxable income. Common deductions include those for student loan interest, IRA contributions, and self-employment expenses. Credits, such as the child tax credit or education credits, directly reduce your tax liability dollar-for-dollar. Understanding these can help you assess your overall tax situation and the potential benefit of realizing capital losses.

Deadlines and Extensions (General)

Be aware of the general tax filing deadlines. For most individuals, this is April 15th. If this date falls on a weekend or holiday, the deadline shifts to the next business day. If you anticipate needing more time, you can file for an extension, which typically grants you an additional six months to file your return. However, an extension to file is not an extension to pay; any estimated taxes owed are still due by the original deadline to avoid penalties and interest.

Step-by-step (simple workflow)

Implementing tax-loss harvesting requires careful planning and execution. Here’s a straightforward workflow:

1. Review Your Investment Portfolio:

• What to do: Examine all your taxable investment accounts (brokerage accounts, not IRAs or 401(k)s) for any investments that are currently trading at a loss.
• What “good” looks like: You have a clear list of investments with unrealized losses and their purchase prices.
• Common mistake: Overlooking investments held in multiple accounts or failing to track the cost basis accurately.
• How to avoid it: Use your brokerage statements and tax forms (like Form 1099-B) to create a consolidated list. Double-check cost basis information.

2. Identify Realized Losses:

• What to do: Decide which of these losing investments you want to sell to realize the capital loss.
• What “good” looks like: You’ve chosen specific securities to sell and have calculated the exact amount of the capital loss for each.
• Common mistake: Selling investments without a clear strategy or understanding the total loss amount.
• How to avoid it: Calculate the loss for each position by subtracting the sale price from the adjusted cost basis.

3. Offset Capital Gains:

• What to do: Use the realized capital losses to offset any capital gains realized in the same tax year. Short-term losses first offset short-term gains, and long-term losses first offset long-term gains. Then, net losses can offset the other type of gain.
• What “good” looks like: Your capital gains for the year are reduced or eliminated by your realized losses.
• Common mistake: Incorrectly applying losses to the wrong type of gains (short-term vs. long-term).
• How to avoid it: Understand the distinction between short-term (held one year or less) and long-term (held more than one year) capital gains and losses.

4. Offset Ordinary Income:

• What to do: If your net capital losses exceed your capital gains, you can use up to \$3,000 of the net loss (or \$1,500 if married filing separately) to offset your ordinary income each year.
• What “good” looks like: Your taxable ordinary income is reduced by the maximum allowable amount from capital losses.
• Common mistake: Assuming all net capital losses can offset ordinary income without limit.
• How to avoid it: Remember the \$3,000 annual limit for offsetting ordinary income.

5. Carry Forward Excess Losses:

• What to do: If you have net capital losses remaining after offsetting all capital gains and the \$3,000 of ordinary income, the excess loss can be carried forward to future tax years.
• What “good” looks like: You’ve accurately calculated and documented any excess losses to be used in the following years.
• Common mistake: Forgetting to track and report carried-forward losses on future tax returns.
• How to avoid it: Keep meticulous records of your tax returns, noting any capital loss carryforwards.

6. Consider the Wash-Sale Rule:

• What to do: If you plan to repurchase a similar investment, ensure you wait at least 31 days before or after selling the losing security to avoid triggering the wash-sale rule.
• What “good” looks like: You’ve either waited the required period or purchased a security that is not “substantially identical.”
• Common mistake: Repurchasing the same or a very similar security too soon, invalidating the loss.
• How to avoid it: Understand what constitutes “substantially identical” (e.g., the same ETF or mutual fund, or options/convertible securities of the same company). Consider diversifying into a different but comparable investment if you need to maintain market exposure.

7. Rebalance or Reinvest (Optional):

• What to do: After selling a losing investment, you might want to reinvest the proceeds into a similar, but not substantially identical, investment to maintain your asset allocation.
• What “good” looks like: You’ve reinvested in a way that aligns with your investment strategy and adheres to the wash-sale rule.
• Common mistake: Reinvesting in the exact same security, thus triggering the wash-sale rule.
• How to avoid it: Choose a different ETF or mutual fund with a similar investment objective, or a different company’s stock in the same sector.

8. Report on Your Tax Return:

• What to do: Report your capital gains and losses on Schedule D (Capital Gains and Losses) and Form 8949 (Sales and Other Dispositions of Capital Assets) of your tax return.
• What “good” looks like: All realized gains and losses are accurately reported, and the resulting tax impact is correctly calculated.
• Common mistake: Failing to report all transactions or miscalculating the net capital gain or loss.
• How to avoid it: Use your brokerage’s tax forms as a guide but always verify the information. Consider using tax software or a tax professional.

Common mistakes (and what happens if you ignore them)

| Mistake | What it causes | Fix