How tax loss harvesting lowers your capital gains bill
Seeking better after tax outcomes is a core part of our Wealth Management and Family Office services. One widely used strategy that US tax law permits is tax loss harvesting. This article explains how tax loss harvesting lowers your capital gains bill in many situations. In addition, it covers the limits and rules that apply.
How tax loss harvesting lowers your capital gains bill
The math starts with netting. In accounting terms, the goal is a smaller gain or a net loss from this simplified formula:
Net gain or net loss = (long term capital gains minus long term capital losses) + (short term capital gains minus short term capital losses).
In other words, the investor realizes losses in the portfolio to offset gains realized during the same year. As a result, the tax owed on those gains may shrink or disappear. The gains can come from selling positions. They can also come from capital gain distributions that mutual funds pay to the portfolio.
In addition, IRS rules let taxpayers deduct up to $3,000 of net capital losses against ordinary income yearly. For married taxpayers filing separately, the limit is $1,500. The limit applies per tax return, and your CPA can confirm how it affects you.
What happens when losses exceed gains
Sometimes losses in one year exceed gains plus the annual deduction. In that case, individual taxpayers can generally carry the unused loss forward to future years. Those carryover losses can then offset gains realized later. Meanwhile, tax on gains realized this year is generally due for this tax year.
Consider a hypothetical example for illustration only. Suppose an investor realizes $20,000 in gains and $30,000 in losses in one year. First, the losses offset all $20,000 of gains. Next, up to $3,000 of the remaining loss may reduce ordinary income. Finally, the other $7,000 can carry forward to later years. Actual results depend on each person’s tax situation.
Deferral, not always savings
Of course, the replacement investment usually carries a lower cost basis than the position sold. Therefore, a larger gain may appear when the investor sells it later. In many cases, the strategy defers tax rather than eliminating it. Benefits also depend on tax rates, holding periods, and trading costs.
The portfolio comes first
In our view, tax savings should never drive investment decisions on their own. Instead, the portfolio should stay aligned with its specific investment objectives. Above all, families should coordinate this strategy with their CPAs and other advisers. That coordination is central to how tax loss harvesting lowers your capital gains bill without distorting the portfolio. This article is educational and is not tax advice.
Watch the wash sale rule
In practice, advisers must consider several IRS rules before making portfolio changes. The best known is the wash sale rule. Congress wrote it to discourage selling assets at a loss purely for a tax benefit. A wash sale generally occurs when an investor sells a security at a loss. It applies if the investor buys a substantially identical security within 30 days before or after the sale. Purchases in a spouse’s account or an IRA can also trigger the rule. In that case, the IRS disallows the loss for now and adds it to the basis of the new position.
How to read an illustrative swap
For example, an investor might sell a fund that tracks the S&P 500 index at a loss. Instead, the investor could buy a fund tracking a different index, such as the Dow Jones Industrial Average. The two indexes often move similarly, but their holdings differ. However, similar is not identical, so the replacement may perform differently. Whether two funds count as substantially identical is a question for your tax professional. This illustration is not a recommendation to buy or sell any security.
