What is tax-loss harvesting?

“Tax-loss harvesting,” in its simplest form, is the sale of a capital asset at a loss to “mop up” tax that would otherwise be due on capital gain from the sale of another capital asset. Capital losses are then applied against capital gains that flow through to an individual U.S. taxpayer and are reported on the taxpayer’s IRS Form 1040, Schedule D.

Tax-loss harvesting can be done on a standalone basis, or it can be combined with various investment strategies. In this series, I will explore common investment strategies that are often combined with tax-loss harvesting: passive investment in an index fund; investing in a broad-based stock index; investing in both a long and a short portfolio; and combining actively managed long and short portfolios with a passive index fund investment. These strategies are addressed in greater detail in Part III.

Why do some taxpayers want to generate tax losses?

It is safe to say that taxpayers typically do not want to generate tax losses. No one would invest one million dollars to generate one million dollar’s worth of losses so their investment is worth nothing. Taxpayers need to believe their investments are appropriate. Obviously, not all investments are profitable, market prices fluctuate, and tax laws change. Taxpayers who engage in tax-loss harvesting seek to reduce their current tax burden—offsetting their gains by selling underperforming assets at a loss. When a taxpayer simply uses tax-loss harvesting to report losses to mop up gains, the taxpayer’s investment portfolio shrinks over time unless replacement assets are acquired. At some point, there would be a limited opportunity to report gains or losses with the assets remaining in the portfolio. As a result, taxpayers remain invested in the market and combine tax-loss harvesting with one or more investment strategies as they replace securities in their portfolios.

Which taxpayers benefit from tax-loss harvesting?

The taxpayer should be a taxable individual or entity. Tax-loss harvesting is not appropriate for tax-exempt investment frameworks, such as pension and profit-sharing accounts, Section 529 Plans, 401(k) accounts, or Individual Retirement Accounts (IRAs).

Should every taxpayer with investment assets consider tax-loss harvesting?

Just because tax-loss harvesting is available, it does not mean it is appropriate for everyone. In the past, tax-loss harvesting was typically used exclusively by high-net-worth taxable investors. With wide available sophisticated computer technology, tax-loss harvesting is now available to retail customers. But each individual taxpayer must carefully consider their unique circumstances, the costs and benefits, possible tax law changes, market conditions, personal financial goals, and risk tolerances. As with all investment and tax strategies, taxpayers must keep scrupulous records documenting their transactions.

When is it useful to harvest tax losses?

It is appropriate to harvest tax losses whenever the taxpayer has appreciated capital assets it wants to sell and capital assets it can sell at a loss. Tax-loss harvesting opportunities are greatest during volatile and down markets. Fewer opportunities are available in up markets because investments generate fewer losses in rising markets.

How are gains and losses calculated for tax purposes?

When a capital asset is sold for an amount higher than its tax basis, it generates a capital gain. When sold at a price lower than its tax basis, the taxpayer has a capital loss.

What is tax basis and how is it calculated?

Tax basis is the amount that a taxpayer invests in acquiring an asset. It determines the taxpayer’s tax liability upon the sale or other disposition of the asset. Tax basis is calculated by first starting with the asset’s original purchase price; adding any commissions; and making any adjustments for stock splits, wash sales, stock dividends, and capital distributions. The higher an asset’s tax basis, the smaller the taxpayer’s gain or the higher the taxpayer’s loss on its sale; and the lower an asset’s tax basis, the larger the gain or the smaller the loss on its sale.

Are some assets more appropriate than others for tax-loss harvesting?

Yes. Appropriate losses are capital losses that are reported on an individual’s Form 1040, Schedule D. Losses can be generated from a wide range of capital assets, including sales of stocks, debt securities, digital assets, real estate, and the proceeds from the sale of a business. It is a common misperception that tax-loss harvesting can only be done with stock or securities with built-in losses. This is not true. For simplicity in the discussions that follow, I address investing and harvesting losses in stock and securities (collectively referred to as securities). If there are unique considerations for other types of asset classes, I will note them.

Which types of accounts and investment vehicles provide tax-loss harvesting benefits?

Taxpayers typically hold their investments directly or in a separately managed account (SMA). Partnerships, S corporations, and certain trusts—can also be used to harvest tax-losses that flow-through to taxpayers. Although taxpayers can benefit from losses that flow-through to them from certain flow-through entities, taxpayers obviously have much more control over assets they hold directly.

Can taxpayers identify the securities they want to sell to get the best tax result from the sale?

Yes. Taxpayers can specifically identify those securities that they want to sell to maximize their losses or minimize their gains. Taxpayers that are able to keep accurate records of the tax basis of their securities can use specific identification. Specific identification is especially important for taxpayers who hold different “lots” of securities purchased at different times and at different prices.

How are capital assets defined for tax purposes?

For tax purposes, assets are either ordinary or capital. Investors and traders generate capital gain or loss, while dealers and hedgers generate ordinary income or loss on their transactions.[1]

The Internal Revenue Code (Code) identifies those assets that are not capital assets.[2] It does not define capital assets. Ordinary assets are defined in relevant part to include property held by the taxpayer as (1) stock in trade, (2) inventory, or (3) for sale to customers in the ordinary course of business. Ordinary assets also include supplies used in the taxpayer’s business, hedging transactions, and commodity derivatives entered into by a taxpayer who is a commodity derivatives dealer. Assets that are not specifically enumerated in the Code are treated as capital assets.

How are capital assets taxed?

The tax treatment of capital gains and losses is based on whether the asset has been held for more than one year. Capital assets held for more than one year, are treated as long-term assets; if held for less than one year, they are short-term assets. Long-term capital assets are taxed at a lower rate than short-term assets—so taxpayers often seek to hold capital assets long enough to qualify for long-term treatment. As a result, taxpayers often (1) selectively sell gain positions once they are eligible for long-term capital gain treatment; (2) selectively sell loss positions to reduce their tax obligations on their sales of gain positions; and (3) reinvest their sales proceeds in other securities that meet their investment objectives. In addition to tracking holding periods, taxpayers must offset short-term losses against short-term gains, and long-term losses against long-term gains.

What is the tax difference between short-term and long-term capital gain?

Short-term capital gain is taxed at ordinary income rates of up to 37 percent,[3] while the highest tax rate for long-term capital gain is currently 20 percent. This 17 percent tax rate differential provides an obvious incentive for taxpayers to hold on to their gain positions.

In addition to offsetting capital gains with capital losses, up to $3,000 of ordinary income can also be offset by capital losses on an annual basis.[4] Capital losses that are not used in the first year they are generated can be carried forward indefinitely, applied on a yearly basis against capital gain plus up to $3,000 of ordinary income. Losses carried forward remain classified as “short-term” or “long-term,” depending on the taxpayer’s original holding period at the time of sale. Taxpayers who carryforward short-term losses might choose to sell short-term capital gain assets to apply against those losses that are carried forward.

In summary, after considering different marginal tax brackets and holding periods, taxpayers benefit the most from generating short-term capital losses and long-term capital gains.

What are some possible advantages to tax-loss harvesting?

Tax-loss harvesting offers various tax advantages while it does not increase the taxpayer’s risk of engaging in any particular investment strategy. Taxpayers may reduce their taxable income; push current income into future years when they anticipate being in a lower marginal tax bracket; permanently deferring tax on appreciated assets that they subsequently donate to charity or bequest to their heirs upon their death.

An advantage with making a charitable contribution is that taxpayers do not pay tax on any unrealized appreciation in their donated property. Rather they are able to receive a tax deduction equal to the fair market value of the property they donate. This allows them to contribute highly appreciated securities held for the long-term holding period, while receiving a tax deduction equal to the fair market value of the donated property. Taxpayers can therefore avoid selling appreciated securities, paying capital gains tax, and contributing only the net proceeds to charity.

Another permanent deferral is available to taxpayers who leave appreciated assets to their heirs. The portfolio securities receive a step up in tax basis equal to the fair market value of the securities at the decedent’s date of death. This allows their heirs to receive portfolio securities at their fair market value rather than with a lower carryover basis. In addition, the decedent’s estate does not need to pay tax on any untaxed appreciation. This permanently avoids capital gains tax.

What should taxpayers look out for and avoid when harvesting tax losses?

As I will discuss at great length in Part II, the big thing to avoid is the wash sales rule. Taxpayers who sells securities at a loss can inadvertently trigger a wash sale if they buy “substantially identical” stock or securities within 30 days before or 30 days after the loss transaction (the 61-day period). A taxpayer who triggers a wash sale cannot currently deduct the loss, and the loss is then added to the tax basis of substantially identical securities that are purchased in the 61-day period. The loss is deferred until the substantially identical securities are subsequently sold by the taxpayer. To avoid the wash sales rule, securities bought within the 61-day period can be similar to—but not substantially identical to—those securities sold at a loss. If taxpayers subsequently donate or bequeath the shares to their heirs, they are deprived of the economic benefit of that loss forever.

Can tax-loss harvesting offset gains generated by investments in regulated investment companies?

No. Gains received from companies regulated under the Investment Company Act of 1940 include mutual funds, exchange-traded funds (ETFs), and other entities regulated as investment companies (collectively, “mutual funds”). Gains and losses distributed by mutual funds to their shareholders are not appropriate to apply against capital losses. This is because short-term capital gain distributions from mutual funds are generally treated as ordinary income (unlike typical capital assets). Mutual fund gains are not reported on an individual taxpayer’s Form 1040 Schedule D.

Taxpayers who sell their mutual fund shares at a gain, however, can offset those gains with capital losses generated by tax-loss harvesting. They can also sell their mutual fund shares at a loss and use those losses to offset capital gains from other sources. In other words, losses on the sale of mutual fund’s shares—unlike losses incurred by a mutual fund itself—are capital assets that are reported on an individual’s Form 1040, Schedule D.

Can tax-loss harvesting affect the availability of “qualified dividends”?

Yes. Dividend income is usually taxed at ordinary income rates, except for those dividends that meet the definition of “qualified dividend income.” Qualified dividend income is taxed at an individual’s long-term capital gain rate. Because these dividends—unlike ordinary dividend that are taxed at the shareholder’s marginal tax rate—generate capital gain, taxpayers might want to harvest tax losses to mop up capital gain from qualified dividends.

A “qualified dividend” is received from certain domestic and foreign corporations that are identified in Code Section 1(h)((11).[5] To be taxed as a qualified dividend, taxpayers must hold the stock in a qualified entity that is generating the dividend for the minimum “unhedged holding period.” This means that taxpayers cannot hold any offsetting positions for a 121-day period that begins 60 days before and ends 60 days after the ex-dividend date.[6] Because they must hold the stock unhedged, a tax-loss harvesting transaction that results in a risk reduction transaction during the unhedged holding period can prevent the dividend from being treated as a qualified dividend.

Holding stock that is eligible for qualified dividend treatment provides variable tax advantages, depending on the taxpayer’s current income levels and tax filing status. Qualified dividends can be taxed at a rate of between zero and 20 percent. Non-qualified dividends, on the other hand, are taxed at the taxpayer’s marginal tax bracket, which can be at a rate of up to 37 percent.

Is tax-loss harvesting suitable to offset gains on “qualified small business stock”?

No. Gains on the sale of shares of qualified small business stock (QSBS) are not suitable to offset with capital losses from tax-loss harvesting. This is because Code Section 1202 allows taxpayers to avoid paying taxes on up to 100 percent of their gain on their QSBS shares. If taxpayers hold QSBS shares for more than five years, gains are tax-free. If they sell their QSBS shares before five years have passed, however, they can defer tax on their QSBS proceeds if they invest the proceeds in shares of another QSBS.

QSBS stock is stock that meets various statutory requirements. First, its shareholders cannot be corporations; they must be individuals, trusts, or estates. Second, the stock must be held for more than five years for the holder to receive the 100 percent gain exclusion. Third, the stock must be acquired on its original issuance directly from the issuer. And fourth, the corporate issuer must have assets with less than $50 million of tax basis at the time the stock was issued.

What should taxpayers keep in mind when waiting until year end to harvest tax losses?

Yes. Loss transactions must be settled before the end of the year in which taxpayers want their losses to apply against capital gains. Although tax-loss harvesting can be done at any time during the year, taxpayers often wait until year-end to take tax losses so they have a better sense of their tax obligations for the year. As year-end approaches, taxpayers should pay careful attention to settlement dates to ensure that harvested losses actually offset gains in the same tax year in which they are reported.

[1] Investment expenses are not associated with a trade or business, so they are not deductible under I.R.C. § 162. Rather, taxpayers need to refer to I.R.C. § 212 to see if its investment expenses are deductible.

[2] I.R.C. § 1221(a).

[3] The maximum long-term capital gain rate applies to married taxpayers filing jointly with annual income exceeding $250,000; married taxpayers filing separately with their individual annual incomes exceeding $125,000; and individuals with annual income exceeding $200,000. Individuals, estates, and trusts with modified adjusted gross income above certain levels are subject to an additional 3.8 percent net investment income tax (NIIT). NIIT applies to long- and short-term capital gains. See, IRS, Topic no. 559, Net Investment Income Tax (Jan. 2, 2025), available at https://www.irs.gov/taxtopics/tc559.

[4] The $3,000 deduction against ordinary income is the same regardless of whether spouses file joint or separate tax returns.

[5] U.S. domestic corporations generally qualify for this treatment and certain foreign corporations also qualify.

[6] I.R.C. § 1(h)(11)(B)(iii).