When it comes to smart tax planning, few strategies are as effective and underutilized as tax-loss harvesting. By strategically selling investments that have declined in value, investors can offset capital gains realized during the year, thereby reducing their taxable income and potentially increasing their tax refund. This approach, known as harvesting losses to offset gains, is a powerful tactic to manage investment portfolios with tax efficiency in mind.
In this blog, we’ll break down what tax-loss harvesting is, how it works, and how you can use it to your advantage when filing your return—especially when dealing with capital gains.
What Is Tax-Loss Harvesting?
Tax-loss harvesting is the process of selling a security—such as stocks, mutual funds, or cryptocurrency—at a loss in order to offset capital gains realized from other investments. This helps reduce the amount of tax you owe on your gains, and in some cases, may result in a larger IRS refund.
For example, if you sold one investment and made a $5,000 gain, and you sell another with a $3,000 loss, you only pay tax on the net gain of $2,000.
Types of Capital Gains and Losses
Understanding the difference between short-term and long-term capital gains is important in tax-loss harvesting:
- Short-term capital gains: Gains from selling assets held for one year or less; taxed as ordinary income.
- Long-term capital gains: Gains from selling assets held longer than one year; taxed at preferential rates (0%, 15%, or 20%).
Losses must first offset gains of the same type. If you have excess losses beyond your gains, you can deduct up to $3,000 of capital losses ($1,500 if married filing separately) against your other income, such as wages or salary.
How Tax-Loss Harvesting Works
The mechanics of tax-loss harvesting involve three main steps:
- Review your portfolio for underperforming investments that are currently valued below their purchase price.
- Sell those assets to realize the loss.
- Use the realized losses to offset realized capital gains or up to $3,000 of ordinary income.
Unused losses can be carried forward to future years, allowing long-term tax planning benefits.
Example of Tax-Loss Harvesting
Let’s say Jane had the following transactions during the tax year:
- Sold Apple stock at a gain of $6,000 (long-term)
- Sold a mutual fund at a $2,500 loss (long-term)
- Sold cryptocurrency at a $2,000 loss (short-term)
Here’s how the taxes work out:
- $2,500 long-term loss offsets the $6,000 long-term gain → Net long-term gain = $3,500
- $2,000 short-term loss can offset any remaining short-term gain, or up to $3,000 of ordinary income
Result: Jane only pays tax on $1,500 of capital gains and can deduct the remaining $500 from her ordinary income—leading to a significantly reduced tax bill or larger refund.
Wash Sale Rule: What to Avoid
One of the key restrictions to keep in mind when using this strategy is the wash sale rule. The IRS disallows a loss deduction if you sell a security at a loss and then buy the same or a “substantially identical” security within 30 days before or after the sale.
This rule prevents investors from selling at a loss just to claim a deduction and then immediately re-entering the same investment. Violating this rule results in the disallowed loss being added to the cost basis of the newly purchased security.
What Qualifies as a Substantially Identical Security?
The IRS doesn’t provide a definitive list, but examples may include:
- Selling an ETF tracking the S&P 500 and buying another S&P 500 ETF within the 30-day window
- Selling shares of one mutual fund and purchasing a nearly identical one from the same fund family
To avoid wash sale issues, you can either:
- Wait 31 days to repurchase the same investment
- Buy a similar, but not substantially identical, investment to maintain portfolio exposure
Timing Considerations
Most tax-loss harvesting occurs near year-end as part of annual tax planning, but you can harvest losses any time during the year. In fact, volatile markets often create opportunities mid-year to lock in losses for future use.
Be mindful of recordkeeping, especially for crypto and frequent stock trades. Use brokerage tax summaries or tools to track your realized and unrealized gains and losses.
Impact on State Taxes
Most states that tax capital gains also allow capital loss deductions in a similar manner to the federal government. However, rules can vary, so it’s important to check your state’s tax code to ensure you’re maximizing your benefit.
Carrying Forward Capital Losses
If your capital losses exceed your capital gains and the $3,000 annual limit for ordinary income offset, the remaining loss is carried forward indefinitely. Each year, you can continue to deduct up to $3,000 against income or use it to offset gains as they occur.
This means even a single year of large losses can reduce your tax bills for many years to come.
Tax Forms Involved
- Form 8949: Used to report individual sales of capital assets including cost basis and proceeds
- Schedule D: Summarizes total capital gains and losses and determines net gain or deductible loss
- Form 1040: Where the final capital gain/loss figure is entered to calculate your total tax
Who Benefits Most from Tax-Loss Harvesting?
This strategy is especially valuable for:
- High-income investors with large capital gains
- Crypto traders with volatile holdings and no broker-reported 1099s
- Long-term investors who wish to reset cost basis on underperforming assets
- Those who anticipate capital gains in the near future and want to “bank” losses for later
Automated Tax-Loss Harvesting
Robo-advisors like Betterment, Wealthfront, and others now offer automated tax-loss harvesting. These services continuously scan your portfolio for harvesting opportunities and rebalance your holdings while avoiding wash sale violations.
This is ideal for hands-off investors who still want to maximize tax efficiency.
Conclusion
Harvesting losses to offset capital gains is a strategic and effective way to lower your tax bill and potentially boost your IRS refund. By selling underperforming investments, avoiding the wash sale rule, and leveraging carryforward losses, you can manage your portfolio in a way that maximizes tax efficiency year after year. Whether you’re an active investor, a crypto trader, or a retirement-focused saver, tax-loss harvesting is a valuable tool that belongs in your financial toolkit. For optimal results, consider consulting a tax advisor or financial planner to align this strategy with your overall goals.
