Tax-Loss Harvesting Basics Every Investor Should Know

All investments carry some risk. However, with a strategy known as tax-loss harvesting (TLH), you can use investment losses to reduce your taxes, redirect the money you save to a different investment, and potentially bump up your long-term capital gains.

Let’s look into the basic principle of tax-loss harvesting and how to make sure you use it for your benefit.

How Tax-Loss Harvesting Works

At its core, tax-loss harvesting involves three basic steps:

1. Examining your investment portfolio to see which investments, like stocks or mutual funds, are making a profit and which are underperforming
2. Selling the underperforming investments at a loss, which may allow you to offset taxable capital gains on the investments that appreciated in value
3. Reinvesting the money you save into a different, more profitable investment

Short-term losses will apply to offset short-term capital gains and long-term losses to long-term capital gains. However, excess losses of both types can apply to either short- or long-term gains.

Even better, capital losses have no expiration date. For example, if your investments took a capital loss of $2,000 but your capital gain was only $1,000, you can roll over the remaining $1,000 to the following tax year.

How Tax-Loss Harvesting Can Reduce Taxable Income

What if you haven’t made any proceeds on your investments and thus have no capital gains to offset? You can also use tax-loss harvesting to lower your taxable ordinary income by up to $3,000 (or $1,500 for married taxpayers filing jointly).

Here’s an example of how it works. Let’s say Brian, a single taxpayer, holds stocks in a tech company. Brian purchased his holdings for $5,000, but now they are only worth $2,000. Brian liquidates his stocks, losing $3,000.

Now Brian can apply this capital loss of $3,000 to his taxable income. Supposing Brian’s marginal tax rate equals 35%, he could qualify for a tax benefit of $3,000 x 35% = $1,050. Brian can take these savings and use them to purchase different stocks and rebalance his portfolio.

Tax-Loss Harvesting Limitations

With all the potential benefits of tax-loss harvesting, this investment strategy has its limitations. Keep in mind that:

• Tax-loss harvesting only applies to taxable brokerage accounts, but not to IRAs or 401(k)s.
• TLH does not cancel tax payments—it only postpones them. This tactic can boost your current cash flow, which you can use to grow your portfolio. However, eventually, you will need to pay capital gains tax.
• TLH reduces an investment’s cost basis. If you use TLH when an investment is at its low point, and then redirect the saved capital to an investment that rises sharply in value, the steep appreciation curve may lead to big profits but also to a high taxable capital gain.
• The wash-sale rule places some restrictions on tax-loss harvesting. Specifically, you cannot purchase “substantially identical” securities within 60 days — 30 days either before or after — of selling your investment at a loss.

To make sure you use TLH in a way that generates capital and avoids excess taxation, we strongly recommend consulting a qualified financial advisor or tax specialist before applying this method to your investment portfolio.

Levy & Associates, Tax Consultants: Fast and Efficient Solutions for All Your Tax Problems

To benefit from tax-loss harvesting, you must understand and comply with IRS requirements. At Levy & Associates, our team of CPAs, tax attorneys, and former IRS specialists can help you cut your tax liabilities and resolve complications like tax liens, levies, and other penalties.

For advanced personalized tax solutions, call (561) 325-6881 to reach our Delray Beach, FL, office, (313) 447-1704 for our branch in Lathrup Village, MI, or contact us online.