Tax-loss harvesting is, simply put, a way to turn a loss (in the market) into a positive. It’s a way to increase returns indirectly by selling losing equities and replacing them soon after to keep your market exposure constant.
In other words, tax-loss harvesting is a technique that allows you to use losses to minimize taxes while at the same time not changing your position or portfolio substantially.
How It Works
Suppose you invest $25,000 in 5 different stocks at $5,000 each. Imagine that one of those stocks loses half its value and is now worth $2,500. Instead of whining, you sell your shares of that stock and immediately reinvest the $2,500 in another similar (but not identical) stock. You haven’t changed your exposure but you can now claim a $2,500 loss.
If, by some miracle, your new stock doubles before the end of the year, your $2,500 tax-loss harvest would now partially offset the gain, depending on your capital gains tax rate.
As you might imagine, the IRS won’t let you buy stock, sell it at a loss, claim the loss and immediately buy the same stock back and not pay taxes on any resulting gain. Through something known as the “wash-sale rule” you can’t buy the same or a substantially identical stock within 30 days. So, either you wait a month or buy another stock. This other stock can be one of “high correlation” just not “substantially identical.”
An example of a highly correlated asset would be to replace the SPDR S&P 500 ETF with the SPDR Dow Jones industrial average ETF. These two equities are highly correlated but not substantially identical.
Another rule says only up to $3,000 of loss can be used to reduce taxable income (assuming you are married and filing jointly). Remember gains offset losses so being able to claim $3,000 is not really a severe limitation.
If it is, and your losses exceed $3,000, they can be carried forward for use on future tax returns. There will be a slight lessening of the time value of money but you will essentially eventually get to claim the loss.
Transaction fees can limit the amount of tax-loss harvesting you can do without losing money. Normally you would want to use the technique only if the tax benefit outweighs the administrative cost.
For this reason, tax-loss harvesting requires careful monitoring and awareness of all fees and administrative costs to make it worthwhile.
Must Involve Long-Term Investments
If you hold your portfolio for less than one year, you can’t benefit from the difference between short-term capital loss and long-term capital gain tax rates. Otherwise, you are simply trading a write-off now for a tax bill later.
The higher the tax rate, the more you save. Importantly, the tax rate you pay on the ultimate gain must be lower than the rate at which you benefit from your harvested loss. In other words, your loss creates value at the short-term capital loss rate and the ultimate gain is taxed at the much lower long-term capital gains rate.