Tax Loss Harvesting

Tax Loss Harvesting Rules Explained

7 min read

Tax loss harvesting sells some investments at a loss to offset other investment gains. You’re trying to keep your income tax down. Once you start playing the investing and trading game, you’ll lose money on some and make lots on others. Of course, we want to be in the latter boat. And if we’re incredibly savvy with our investments and trades, our boat is filled with gold, diamonds, cash, and all the otherworldly treasures money can buy. It’s time to go shopping!!!! Or is it? Don’t get excited yet. The taxman wants a piece for all those thousands of dollars in gains you made. Let me introduce you to the dreaded capital gains tax and how tax-loss harvesting can help avoid the taxman.  

To understand tax loss harvesting, we need to know what defines capital gains. A capital gain is when you sell an investment or an asset for a profit. Unfortunately, the government considers these proceeds income and taxes, which is no surprise. 

Tax-loss harvesting takes losing positions inside a portfolio and uses those to offset potential gains or realize gains you already have. 

In simple terms, you sell an investment worth less than what you bought it for. You then turn around and sell an investment worth more than what you bought it for. The loss on the one helps to offset the gains on the other. 

Tax Loss Harvesting

Short vs. Long-Term Capital Gains Tax

The amount you owe in capital gains tax partly depends on how long you owned the asset. Long-term capital gains are from an asset you’ve held for over a year.

Alternatively, short-term capital gains apply to profits from selling an asset you’ve held for less than a year.

The tax owed depends on the length of time you held the security and your marginal tax bracket. In some cases, that could mean you could pay up to 37% income tax, depending on your federal income tax bracket.

More often than not, I find myself on a sinking ship when it comes to trading. I know someone in a trade about a million dollars in the wrong direction. Images of the Titanic are conjuring up in my head -cringe. 

But there’s a bright side to this sinking ship. Let me introduce you to tax-loss harvesting.

5-Second Take Away

  • When you sell an investment or an asset for a profit, it’s considered a capital gain.
  • You’ll owe capital gains tax if you have a capital gain on any investments/assets you sell
  • Use tax-loss harvesting to avoid capital gains tax
  • You can only do tax-loss harvesting in your taxable brokerage accounts
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Real-Life Tax Loss Harvesting Example

Let’s say it’s December, and you made a profit throughout the year in your trading account. You silently thank Bullish Bears for their trading courses.

Undoubtedly, you don’t want to pay taxes. So, how do you get around this? Well, the solution is quite simple:

Tax-loss harvesting. You can sell any amount of losing positions to offset the capital gains in your winning positions. 

In fact, you can go into the negative and report as much as a $3000 capital loss on your taxes. You can carry the additional dollars to subsequent tax years if you have more than a $3000 capital gain and a $5000 loss.

The IRS would allow you to claim $3000 this year, and they would let you use the other $2000 next year. Click here for additional details. 

Rebalancing Your Portfolio

Tax-loss harvesting is a common approach for rebalancing portfolios. Let’s walk through an example. One Sunday afternoon, you decide to take a look at your portfolio. Upon closer examination, you notice the tech stocks you went heavy on have soared in value.

But, unfortunately, the healthcare stocks you have tanked. So, now your portfolio is overweight in tech stocks. However, you want to sell some to lock in the profits because they’re so profitable.

So, you sell some of those tax stocks, realizing a taxable gain. But you’re savvy. You don’t want to pay any money to the taxman, so you sell some of your healthcare stocks, realizing a loss.

Next, you turn around and reinvest the proceeds in a way that balances your portfolio. And when tax time comes, the loss on the healthcare stocks offsets the gain on the tech stocks. As a result, you won’t owe any capital gains taxes. 

As mentioned above, the IRS allows you to use up to $3000 of the remaining capital loss to lower your taxable income. So, in the example above, the final $2000 is carried forward and could be used to offset income in future tax years. 

Tax Benefits Based on Marginal Tax Rate

Assuming you sit in the 35% marginal tax rate bracket, your overall tax benefit could be \$8000.50. So even if you don’t have any capital gains to offset, any investment losses in the current tax year could reduce your taxable income by up to \$3000. That’s pretty impressive if you ask me. 

Tax Loss Harvesting Rules

It should come as no surprise that there are also some rules to remember when dealing with the government. For example, you can only harvest tax-loss in your taxable brokerage accounts – not in 401(k)s or IRAs. 

Also, you have to use short-term losses to offset short-term gains and long-term losses to offset long-term gains. But, if you have excess losses in either category, they can be applied to either type of gain. 

Beware of the 30 Day Rule

It should come as no surprise that there are also some rules to remember when dealing with the government. For example, you can only harvest tax-loss in your taxable brokerage accounts – not in 401(k)s or IRAs. 

Also, you have to use short-term losses to offset short-term gains and long-term losses to offset long-term gains. But, if you have excess losses in either category, they can be applied to either type of gain. 

Final Thoughts

Be smart, and you might have a boatload of tax-free gold. But first, consult your tax or financial planning professional to see how tax-loss harvesting could fit into your tax or financial planning process picture.

Frequently Asked Questions

You can get back up to $3,000 yearly from tax loss harvesting. If you lose over $3,000, you can carry it over to the next tax year.

The IRC limits loss to $3,000 a year against ordinary income. Any more than that you must carry over to the next tax season. 

This is also known as the wash sale rule. You can't claim the loss if you lose money on a trade but go back into it within 30 days. 

It can be worth it. But it would be best if you didn't base your strategy on selling for a loss to get it back in taxes.

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