What Is Tax Loss Harvesting? A Crash-Course by Bust-Down Books

What Is Tax Loss Harvesting? A Smart Strategy to Reduce Your Tax Bill

In investing, losing money is never the goal—but when losses happen, savvy investors know how to turn them into a tax-saving opportunity.

This strategy is called tax loss harvesting, a technique used to offset capital gains, lower taxable income, and improve after-tax investment returns.

While tax loss harvesting doesn’t erase investment mistakes, it can soften the financial blow and make taxes work in your favor. But how does it work, and what should investors watch out for? Let’s break it down.

What Is Tax Loss Harvesting?

Tax loss harvesting is a strategy where investors sell underperforming assets at a loss to offset capital gains taxes on profitable investments.

Key Benefits:

✔ Reduces taxable capital gains
✔ Can lower overall tax liability
✔ Allows reinvestment into similar assets without disrupting portfolio strategy

Example: If you sold Stock A for a $10,000 profit, but also sold Stock B for a $7,000 loss, you would only owe taxes on a net gain of $3,000 instead of the full $10,000.

By strategically selling assets before the end of the tax year, investors can optimize their tax bill and retain more of their investment returns.

How Tax Loss Harvesting Works:

Step 1: Identify Losing Investments

Review your portfolio and identify stocks, ETFs, or mutual funds that are trading at a loss compared to their purchase price.

Step 2: Sell the Losing Asset

Sell the investment to realize a capital loss, which can be used to offset capital gains from other investments.

Step 3: Reinvest Proceeds into a Similar Asset

To maintain your portfolio’s investment strategy, reinvest the proceeds into a similar but not “substantially identical” investment (to avoid violating the Wash Sale Rule—more on that later).

Step 4: Apply Losses to Your Tax Return

Use capital losses to offset capital gains, reducing taxable income.

If capital losses exceed capital gains, up to $3,000 can be deducted against ordinary income per year (or $1,500 if married filing separately).

Excess losses can be carried forward to future tax years.

Example of Tax Loss Harvesting in Action:

Investment     Buy Price         Sell Price         Gain/Loss

Stock A (Gain)              $5,000 $10,000            +$5,000
Stock B (Loss)              $8,000 $4,000 - $4,000
Taxable Gain After Offsetting Losses            $1,000 instead of $5,000

Instead of paying capital gains tax on $5,000, the investor only pays tax on $1,000, significantly reducing their tax liability.

The Wash Sale Rule: Avoiding IRS Penalties

The Wash Sale Rule, enforced by the IRS, prevents investors from selling a losing investment just to claim a tax deduction, then immediately repurchasing the same or a “substantially identical” asset.

If an investor buys back the same stock, ETF, or mutual fund within 30 days before or after the sale, the loss is disallowed for tax purposes.

✔ Allowed: Selling Stock A at a loss and buying a similar stock in the same industry (e.g., selling Microsoft and buying Apple).
X Not Allowed: Selling Stock A at a loss and repurchasing it within 30 days.

Workaround:

Investors can replace sold assets with similar but not identical investments, such as:

✔ Swapping ETFs that track the same industry but use different issuers (e.g., switching from Vanguard’s S&P 500 ETF to a similar BlackRock ETF).
✔ Replacing individual stocks with sector ETFs (e.g., selling Tesla stock and buying an electric vehicle ETF).

Who Should Use Tax Loss Harvesting?
✔ Investors with Taxable Brokerage Accounts – Tax loss harvesting is only beneficial for investors with taxable accounts (not IRAs or 401(k)s, which are tax-advantaged).
✔ High-Income Investors – Those facing high capital gains tax rates benefit the most.
✔ Long-Term Investors – Those who periodically rebalance portfolios can strategically use tax loss harvesting to enhance after-tax returns.

Who Shouldn’t Bother?

Investors who primarily use retirement accounts (401(k), IRA, Roth IRA): Gains and losses in these accounts are tax-deferred or tax-free, making tax loss harvesting irrelevant.

Traders who don’t have capital gains: If you aren’t realizing gains, you may not need to harvest losses.

Common Mistakes to Avoid:

1. Violating the Wash Sale Rule

✔ Always wait at least 31 days before repurchasing the same security.

2. Harvesting Losses Without Offsetting Gains

✔ If you have no capital gains, a loss may not provide an immediate tax benefit, though it can still offset up to $3,000 of ordinary income per year.

3. Ignoring Portfolio Diversification

✔ Don’t sell valuable long-term holdings just for tax benefits if it disrupts your investment strategy.

4. Waiting Until the Last Minute

✔ Plan tax loss harvesting throughout the year, rather than scrambling at year-end.

How Much Can Tax Loss Harvesting Save You?

Short-term capital gains (held <1 year) are taxed at ordinary income tax rates (up to 37%).

Long-term capital gains (held >1 year) are taxed at lower rates (0%, 15%, or 20%).

By offsetting short-term gains first, investors can reduce taxes at the highest rate.

Example Tax Savings:

Tax Bracket    Capital Gains Tax Rate         Tax Savings from $10,000 Loss

12%     0% (for long-term gains)         $0
22%     15%     $1,500
37%     20%     $2,000

High earners benefit the most, especially when offsetting short-term capital gains taxed at ordinary rates.

Does Tax Loss Harvesting Improve Long-Term Returns?

Yes, but only if reinvested properly.

✔ If investors harvest losses but fail to reinvest the proceeds, they might miss out on market rebounds and compounding growth.
✔ If done correctly, tax loss harvesting lowers tax drag and enhances net returns over time.

Is Tax Loss Harvesting Worth It?

✔ For investors with taxable accounts, tax loss harvesting is a smart way to reduce taxes and improve after-tax returns.
✔ It’s not a reason to sell investments you believe in, but a strategy to optimize tax efficiency.
✔ Timing, compliance with the Wash Sale Rule, and reinvestment decisions are key to maximizing benefits.

For those with significant gains or high tax brackets, tax loss harvesting can be a powerful tool—because in investing, it’s not just about how much you make, but how much you keep.