How does tax loss harvesting work?
Tax loss harvesting is when you sell securities for less than their cost basis, or the price you originally paid for them. This captures losses to offset gains you may have realized in other investments, including the sale of real estate, a business or another large asset.
How you match your losses to gains depends on how long you held the assets. Typically, short-term losses—those you held for 12 months or less—are used first to offset short-term gains, and long-term losses of assets held for more than a year are used to offset long-term gains. If you have losses beyond the matching approach, you’re then allowed to apply short-term losses to long-term gains and long-term losses to short-term gains.
Tax loss harvesting example
Let’s say you own shares of Acme Corp. stock and Beta Corp. stock, both held for less than 12 months. If you sell Acme Corp. stock and realize a profit, that profit would be subject to short-term capital gains tax (which is higher than the long-term capital gains tax). You could offset some of that tax liability by also selling shares of your Beta Corp. stock for less than what you paid for them.
The realized short-term capital loss of your Beta stock can be used first to offset the short-term capital gains realized on the sale of your Acme stock. Then, any excess can be used to offset up to $3,000 of your ordinary taxable income ($1,500 for those who are married filing separately). Any amount over $3,000 can be carried forward to subsequent years and used subject to the “passive loss” rules.
“In an ideal scenario, you want to take your losses and offset your short-term capital gains, since they’re taxed at a higher rate,” says Poddar.
But there’s a caveat. If you take a loss, you must stay out of that stock for a month to avoid violating the “wash sale rule.” If you buy back into the position of previously purchased stock within 30 days of its sale, you can no longer claim that loss on your taxes. Instead, under the “wash sale rule,” the loss will be added to the newly acquired stock’s cost basis.