Tax-loss harvesting is a powerful year-end strategy that investors can use to minimize their tax liability by offsetting capital gains with capital losses. Whether you’re a seasoned investor or a casual market participant, knowing how to apply tax-loss harvesting properly can directly reduce your tax bill and increase your refund. This guide will walk you through what tax-loss harvesting is, how it works, and how to report the results accurately on your IRS Form 1040 using Schedule D and Form 8949.
What Is Tax-Loss Harvesting?
Tax-loss harvesting is the process of selling investment assets, such as stocks or mutual funds, that have decreased in value to realize a capital loss. These losses can then be used to offset capital gains from other profitable investment sales. If your total capital losses exceed your capital gains, you can deduct up to $3,000 of those excess losses ($1,500 if married filing separately) from your ordinary income.
The strategy allows you to take advantage of market downturns by reducing taxable income without changing your overall investment strategy.
Key Benefits of Tax-Loss Harvesting
- Reduce taxable capital gains: Minimize or eliminate taxes on profitable investments
- Offset ordinary income: Use up to $3,000 in excess losses annually to reduce wages, salaries, and other income
- Carry over unused losses: Unused losses can be carried forward indefinitely to future tax years
- Optimize investment portfolios: Rebalance your holdings without significant tax cost
When to Harvest Tax Losses
The most common time to harvest losses is near the end of the tax year—typically in November or December. However, you can implement this strategy anytime your portfolio includes securities trading below their original purchase price (cost basis). The key is to do it before December 31 to apply the loss for that year’s tax return.
Eligible Assets for Tax-Loss Harvesting
Tax-loss harvesting can be applied to:
- Stocks and ETFs
- Mutual funds
- Cryptocurrencies (as of 2025, crypto is not subject to the wash-sale rule)
- Real estate (under certain conditions)
Note: Assets held in tax-advantaged accounts such as IRAs or 401(k)s are not eligible for tax-loss harvesting.
Understanding Short-Term vs. Long-Term Capital Gains and Losses
The IRS treats capital gains and losses differently depending on how long you held the asset before selling:
- Short-term: Assets held for one year or less, taxed at ordinary income tax rates
- Long-term: Assets held for more than one year, taxed at preferential long-term capital gains rates (0%, 15%, or 20%)
When applying losses, the IRS requires you to offset:
- Short-term losses against short-term gains
- Long-term losses against long-term gains
- Net losses of one type can then be used to offset gains of the other type
The Wash-Sale Rule
One important caveat is the wash-sale rule. The IRS disallows a capital loss deduction if you purchase the same or a “substantially identical” security within 30 days before or after the sale that generated the loss. This includes:
- Buying back the same stock or fund
- Buying a substantially identical fund (e.g., similar ETFs tracking the same index)
- Purchases by a spouse or a retirement account
To avoid a wash sale, consider replacing the security with a similar, but not identical, asset or waiting the full 30-day period before repurchasing.
Steps to Perform Tax-Loss Harvesting
- Review your portfolio: Identify investments currently valued below your cost basis
- Sell the underperforming assets: Trigger a realized capital loss by completing the sale
- Avoid the wash-sale rule: Either wait 31 days to repurchase or invest in a different security
- Track and document all transactions: Keep brokerage records and cost basis calculations
- Report the losses on your tax return: Use Form 8949 and Schedule D to document the loss and apply it against gains
How to Report Tax-Loss Harvesting on IRS Form 1040
To report capital gains and losses, including those from tax-loss harvesting, you must use:
- Form 8949: To report each sale of capital assets
- Schedule D (Form 1040): To summarize gains and losses from Form 8949
- Form 1040: To reflect the net gain or loss from Schedule D on Line 7 of Schedule 1
Step-by-Step Example
Suppose you sold the following investments:
- Stock A: Gain of $5,000
- Stock B: Loss of $2,000
- ETF C: Loss of $4,000
Total capital gain = $5,000
Total capital loss = $6,000
Net capital loss = $1,000
You would:
- Report all transactions on Form 8949
- Use Schedule D to net the gain and loss
- Enter the $1,000 net capital loss on Line 7 of Schedule 1
- If losses exceeded $3,000, carry the excess to the following year
Carryforward of Excess Losses
If your net capital losses exceed the $3,000 limit for deduction against ordinary income, the remainder can be carried forward to future tax years. There is no time limit on this carryforward—it can be applied until fully used up.
To carry losses forward:
- Complete the Capital Loss Carryover Worksheet in IRS Publication 550 or use tax software
- Track remaining losses each year to apply them properly
- Use in future years to offset gains or deduct up to $3,000 per year from ordinary income
Tax-Loss Harvesting for Crypto Investors
As of tax year 2025, cryptocurrencies are not subject to the wash-sale rule. This allows for more flexibility in harvesting losses from crypto sales while potentially repurchasing the same asset immediately. However, legislative changes may impact this in the future, so monitor IRS updates and guidance.
Tax-Loss Harvesting and Mutual Funds
Mutual fund investors should be especially careful around year-end when funds distribute capital gains to shareholders. Selling a fund before its distribution date can help avoid taxable distributions and trigger a harvestable loss if the fund’s value has declined.
Common Mistakes to Avoid
- Triggering wash sales: Negates the tax deduction
- Harvesting in tax-advantaged accounts: Capital losses inside IRAs/401(k)s are not deductible
- Neglecting to report transactions: Failing to file Form 8949 and Schedule D properly
- Misclassifying gains/losses: Incorrect short-term vs. long-term reporting
Should You Use a Tax Professional or Software?
While many investors manage tax-loss harvesting themselves, using a CPA or robust tax software is often advisable, especially when dealing with complex portfolios or large amounts. A professional can help identify the best assets to harvest, navigate the wash-sale rule, and ensure accurate reporting to the IRS.
Final Thoughts
Tax-loss harvesting is one of the smartest ways to reduce your tax burden while maintaining a disciplined investment strategy. When executed correctly, it allows you to use downturns in the market to your advantage. By offsetting capital gains and applying excess losses against ordinary income, you may significantly lower your total tax liability. Don’t forget to report your transactions correctly using Form 8949 and Schedule D on your Form 1040 and track any unused losses for carryforward. Whether you manage your investments or use an advisor, tax-loss harvesting is a must-know strategy in every investor’s toolbox.
