10 Things to Know About Tax-Loss Harvesting

Learn how to offset capital gain income with a capital loss.

Even the best investment managers, including Warren Buffet, have investments that lose money from time to time. That doesn’t mean the losses are a complete waste, however, especially if you will owe capital gains taxes. Under the tax code, you can use investment losses to reduce taxable income and reduce taxes. Making strategic use of selling investments that have lost money for tax purposes is known as tax-loss harvesting, and it can save you a bundle on your taxes when done properly. Learn how to strategize your investments to minimize taxation.

What You Need to Know About Tax-Loss Harvesting

Everyone likes paying less in taxes, but no one wants to be audited by the Internal Revenue Service. But taxes can be complicated, especially if you’re unfamiliar with what capital gains tax is. So if you’re not sure if it’s the right move for you, talk to a financial advisor or tax preparer. Here are 10 critical things to know about tax harvesting to increase your tax savings:

1. You Should Estimate Your Tax Liability Before Executing Trades

Before you start selling any investments, first estimate what your tax scenario actually looks like for the year. To estimate your capital gains and losses for each stock, subtract your basis from your sale proceeds. Your basis is the amount that you paid for the stock and your sales proceeds are what you received when you sold the stock. For example, if you paid $1,500 and then sold shares and received $1,700, your gain is $200.

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2. Not All Income Is Taxed Equally

The IRS assesses different types of income at different income tax rates. For example, the maximum tax rate on ordinary income, including short-term capital gains, is 39.60 percent, whereas the maximum capital gains tax rate on long-term capital gains is 20 percent. So, if you only have long-term capital gains this year, and you anticipate generating significant short-term capital gains next year, it might be worth waiting to harvest your losses so they offset the short-term capital gains next year.

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3. Long-Term Capital Gains Require Satisfying a Holding Period

In general, to receive the more favorable tax treatment for long-term capital gains, you must have owned the stock for more than one year. If you owned the stock for one year or less, any gains are characterized as short-term capital gains. However, dividends are treated differently: If you hold the stock for at least 60 days during the 121-day period that begins 60 days before the ex-dividend date and ends 60 days after the ex-dividend date, your dividend counts as long-term capital gains.

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4. You Must Offset Gains in a Specific Order

The IRS sets rules for the order in which you must use your capital losses to offset your other income. First, you use any long-term losses to offset any long-term capital gains and use any short-term capital losses to offset short-term capital gains. Then, if you have excess losses remaining, you can use them to offset capital gains of the opposite type. For example, if you have more short-term losses than short-term gains, you can use the excess to offset long-term gains. Finally, if you have more capital losses than gains, you can use those excess losses to offset ordinary income — to an extent.

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5. Capital Losses Have Limits

Though tax-loss harvesting can provide valuable benefits, they aren’t unlimited. Each year, your losses are limited to offsetting your capital gain income for the year, plus an additional $3,000 against other income. However, if you’re married filing separately, the limit for offsetting other income is $1,500. For example, say you’re single and you have $4,000 of capital gains. The maximum capital losses you can benefit from in the current year is $4,000 to $7,000 to offset your gains plus $3,000 to offset other income. You can carry forward any excess losses to use in future years.

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6. Wash Sale Rule Limits Repurchases

The IRS doesn’t allow you to simply sell an investment one day to claim the loss and then buy it back the next day. The IRS disallows any losses resulting from sales if you do any of the following within 30 days of the sale:

  • Buy substantially identical stocks or securities
  • Acquire substantially identical stocks or securities in a taxable trade
  • Acquire a contract to buy substantially identical stocks or securities
  • Acquire substantially identical stocks or securities in an IRA or Roth IRA

For example, you if you sell 100 shares of Apple stock today and then buy 100 shares a week later, even though you aren’t buying back the same 100 shares, you’re still covered by the wash sale rules.

7. Reinvestment in Similar Funds or Companies Is Allowed

The wash sales rules don’t apply, however, if you reinvest the money from the sale in funds or companies that would fulfill a similar role in your portfolio. For example, if you have losses in a technology mutual fund, you could sell your shares in that mutual fund and use the proceeds to purchase a mutual fund with a similar investing philosophy. That way, your portfolio remains on track, and you get to claim your tax losses to reduce your tax liability.

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8. Use Form 1040 for Your Tax Return

Technically, there’s not a separate tax return form just for trades you made for tax harvesting purposes — the trades are reported with all of your other capital gains and losses on Schedule D. However, you will need to use Form 1040 to file your taxes because you’re ineligible to use Form 1040EZ or Form 1040A.

9. You Should Avoid Tax-Loss Harvesting in Retirement Accounts

Even if you take an active role in managing the investments in your retirement accounts, tax-loss harvesting doesn’t apply to retirement accounts, like 401ks or IRAs. That’s because the money in these accounts, unlike an investment account, grows tax-deferred — meaning you don’t pay taxes on the gains or losses that you realize from selling investments in the account. For example, if your IRA owns McDonald’s stock that you purchased for $4,000 and then you sell for $5,000, that $1,000 gain isn’t taxed when you sell it. So, it doesn’t make sense for you to try to offset gains with losses.

10. Tax-Loss Harvesting Shouldn’t Drive Your Investments

Tax-loss harvesting is merely an income tax tactic that can help you with tax-efficient investing — not a substitute for financial planning. While it can save you money, don’t lose sight of your overall investing goals or jeopardize your financial plan for the sake of smaller, short-term tax savings.

Up Next: 9 Best Short-Term Investment Options

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About the Author

Michael Keenan

Michael Keenan is a writer based in the Kansas City area, specializing in personal finance, taxation, and business topics. He has been writing since 2009 and has been published by Quicken, TurboTax and The Motley Fool.

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10 Things to Know About Tax-Loss Harvesting
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