In the world of investing, winning certainly feels good. Winning still isn’t everything. In fact, some investors purposely take losses as a strategic move. This might seem counterintuitive, but this process, known as tax loss harvesting, can benefit retail traders and large-scale hedge funds alike.

We can’t advise you on how to do your taxes – you’d need to consult a licensed, registered professional tax advisor for that – but it’s still worthwhile to learn about the modern practice of tax loss harvesting. By deploying this tax-time life hack, you may be able to keep more of your own money when it’s time to pay the Internal Revenue Service (IRS).

Turning a Bad Year Into a Tax Break

And so, we start with the billion-dollar question: What is tax loss harvesting?

👋 Interestingly, the term tax loss harvesting isn’t an official term employed by the IRS, and it doesn’t appear anywhere in the IRS’s discussion of capital gains.

For the purposes of this discussion, capital gains are the money you’ve made on your profitable investments during the taxable year. Capital losses are the money you’ve lost on your unprofitable investments.

Tax Loss Harvesting and Capital Losses

The concept of tax loss harvesting is intimately related to capital gains and losses. If you had a bad year as an investor and ended up losing money when all is said and done, that’s a capital loss. Of course, the IRS isn’t going to make you pay taxes on your investments that year if you didn’t make money and therefore had a capital loss. You can even deduct up to $3,000 (or $1,500 if you’re married but filing separately) of your capital losses from your taxable income during that losing year.

And so, we’re already observing one of the tax loss harvesting rules: The most that you can “harvest” in any given tax year in the U.S. is $3,000/$1,500. This is true even if you lost a lot more than $3,000/$1,500 in stock, cryptocurrency, bonds, and other investments during the year.

☝ Don’t deliberately try to lose more money than that limit as a tax strategy – it just wouldn’t make sense.

Tax Loss Harvesting and Capital Gains

What if you didn’t have a losing year overall, though? If you come out ahead when all is said and done, then you can’t reap the tax-time benefits of a capital loss on your investments. Moreover, if you finish the year with a capital gain, then you’ll be liable for taxes on that gain. Depending on your total income and other factors, you might have to give 15%, 20%, 25%, or even 28% of the year’s investment profits to Uncle Sam.

So, if there’s a strategy you can use to minimize the capital gains you’ll have to report for the taxable year – and maybe even turn what was a gain into a capital loss for tax purposes – then wouldn’t you want to use this strategy to its fullest extent? That’s exactly what many sophisticated investors do, and if done correctly, it’s perfectly legal.

How Does Tax Loss Harvesting Work?

The strategy is actually quite simple. Before the year ends (and therefore prior to January 1 of the following year), liquidate (which usually means sell) some or all of your losing investments.

As for your winning investments, you can just hold on to them so that you won’t have to pay taxes on the profits until a later time.

In other words, you’re using your losses to offset, either partially or entirely, your profits for the taxable year.

☝ Everything you do within this strategy must be done on or before December 31. Otherwise, the IRS won’t allow it to count for the tax year in question.

All of this will become clearer when we try out a tax loss harvesting example.

👉 For Example

Let’s say you had some great investments and you decided to let some winners run – not a bad move from a taxation perspective. Yet, you did opt to cash out some of your winnings and ended up with a profit of $10,000 in late December.

Congratulations – you did well with your investments. But then, you might regret your investing success when it comes time to pay your taxes, as $10,000 in capital gains could trigger a sizable tax payment. Isn’t there some legal way to lower that tax bill? After all, not all of your investments were winners.

If you had, say, some investments that went awry and would incur $8,000 worth of capital losses if you liquidated them right now, you’d be an ideal candidate for tax loss harvesting.

Before January 1, in this hypothetical example, you could sell those particular losing investments and incur $8,000 worth of capital losses to offset your $10,000 worth of capital gains for that year. Sure, it’s painful and could dent your ego to book those losses, but it just might be the smartest tax move you can make.

In that scenario, your total taxable investment income wouldn’t be $10,000; it would only be $2,000, which means a much lower tax payment.

🤔 Remember: You can only incur a capital gain or loss on investments that you sell. If you don’t sell and take a profit, you won’t be taxed on the gains.

A Rule to “Wash” Out For

Now, let’s modify the scenario.

What if you only took $6,000 worth of profits from your investments that year but still booked $8,000 worth of capital losses from your less-than-ideal investments? In that case, you could harvest $2,000 worth of capital losses when all is said and done, thereby potentially lowering your overall taxable income and keeping more of your money.

Don’t try to be clever and think you’re going to sell those losing investments on December 31, only to buy them back on January 1. The government caught on to this little trick a long time ago, and the IRS has a regulation in place to deter taxpayers from trying it. It’s called the wash sale rule, and it basically means that the IRS won’t allow a capital loss to count for tax purposes if you buy back the same asset – or even a “substantially identical” asset, such as an option that’s based on a stock – within 30 days after you sold it.

The point here is that if you’re selling a stock or other asset near the end of the year for tax loss harvesting purposes, know that you won’t be able to claim that loss with the IRS if you repurchase that asset (or something “substantially identical”) within 30 days.

💡 This shouldn’t prevent you from selling, say, Microsoft stock in late December and purchasing Apple stock in early January; they’re both technology stocks, but aren’t “substantially identical” according to the IRS’s definition.

Is Tax Loss Harvesting Worth It?

So, now you know the basics of tax loss harvesting and what it might look like in action. This still leaves open a fundamental question, though: Is tax loss harvesting worth it?

It’s best to consult a tax professional to get the answer to that question, as the value of tax loss harvesting depends on your individual circumstances. How badly do you want to hold on to your losing investments? Are there reasons to believe that those investments will eventually turn into winners? And how much tax benefit would be gained from selling the losing investments before January 1?

The answers to these and other questions will help to determine whether tax loss harvesting is worth pursuing. It’s a strategy that has helped many investors lower their tax bills year after year, and under the right circumstances, it might be right for you too.

The post What Is Tax Loss Harvesting: How It Works and Is It Worth It appeared first on FinMasters.


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