Tax-loss harvesting works by selling losing investments in your brokerage account to intentionally lock in a capital loss. You then use those losses to cancel out the capital gains you made from selling winning investments, which directly lowers your annual tax bill.
How losses offset gains to reduce your taxable income
When you invest through a standard individual brokerage account, you are required to pay capital gains taxes on your net profits at the end of the year. Tax-loss harvesting is a strategy that lets you use investment mistakes to subsidize your investment wins. The process allows you to subtract your total realized losses from your total realized gains, meaning you only pay taxes on the remaining difference.
The Internal Revenue Service (IRS) separates your capital gains and losses into two distinct bins based on how long you held the asset. Short-term investments are held for one year or less, while long-term investments are held for longer than one year. The rules of harvesting require you to match like with like first. Short-term losses must offset short-term gains, and long-term losses must offset long-term gains. If you have leftover losses in either bin, you can then apply them to the opposite type of gain.
If your total investment losses outweigh your total gains for the year, you do not lose the extra tax benefit. You can use the remaining losses to reduce up to $3,000 of your ordinary taxable income, such as the money you earn from your salary. Any leftover losses beyond that $3,000 threshold can be carried forward to future tax years indefinitely.
Step-by-step guide to harvesting a loss
To successfully harvest a loss without changing your overall investment strategy, you should follow a precise order of operations.
- Identify your losing positions. Log into your brokerage portal and review your specific tax lots to find investments currently trading below your original purchase price.
- Check your recent purchase history. Look back at the last 30 days to make sure you have not bought additional shares of this exact asset, which would complicate the trade.
- Sell the investment to realize the loss. Execute the sell order on the losing shares to officially convert your temporary paperwork loss into a permanent, realized capital loss.
- Buy a similar replacement asset immediately. Take the cash proceeds from the sale and immediately purchase a different security that has a similar market exposure, ensuring your money stays fully invested.
- Report the transaction on your taxes. At the end of the year, your broker will send you a Form 1099-B, which you will use to fill out Schedule D of your tax return to claim your deductions.
The unexpected trap of the wash-sale rule
The biggest trap associated with tax-loss harvesting is triggering a wash sale, which completely ruins your tax benefit. The IRS prevents investors from selling a stock just to claim the tax break and immediately buying it right back.
According to the wash-sale rule, if you sell an asset for a loss, you cannot buy that same asset, or a substantially identical one, within 30 days before or 30 days after the date of your sale. This creates a strict 61-day danger window. If you violate this rule, the IRS disallows your current-year tax deduction completely and adds the lost deduction amount to the cost basis of your new shares instead.
This rule applies across all your personal financial accounts collectively. You cannot sell an index fund for a loss in your individual brokerage account and buy the exact same fund back in your Roth IRA or your spouse’s account the next day. To bypass this issue safely, you must replace your harvested investment with a fund that tracks a completely different index, or simply wait 31 days before buying the original asset back.