For many investors, the practice of investing is mainly about increasing gains. You employ strategies meant to increase the income from your portfolio. However, one important but sometimes underutilized strategy: managing investment losses.
Not all investments will be successful, and a smart investor will know how to leverage these underperforming assets. One practice, in particular, can help you offset taxable gains and reduce your tax liability. This strategy is called tax-loss harvesting, a tactic that allows you to offset capital gains and, if losses exceed gains, up to $3,000 of ordinary income annually.
Understanding the intricacies of tax-loss harvesting can help investors make more informed decisions, particularly when aiming to manage capital gains tax exposure or realign their portfolios. Below, Realized 1031 has shared a guide for this practice, so keep reading to learn more.
What Is Tax-Loss Harvesting?
Tax-loss harvesting is an investment strategy that involves selling off assets or securities at a loss. You can then use this loss to offset realized capital gains and, if applicable, reduce taxable income, especially if you’re facing high income taxes or capital gains taxes for that tax year. When structured appropriately, this approach can help manage tax exposure—particularly in years with significant realized gains or higher income.
The core objective of tax-loss harvesting is not to avoid losses, but rather to use them constructively within the framework of the U.S. tax code. Specifically:
- To offset short-term capital gains, which are taxed at higher ordinary income rates.
- To offset long-term capital gains, which are taxed at reduced rates.
- If your capital losses exceed your gains, you can deduct up to $3,000 ($1,500 if married filing separately) in losses against ordinary income per year, with any remaining loss carried forward to future years.
Thanks to these advantages, tax-loss harvesting becomes an important tool for managing tax liability. But does this practice eliminate losses? No, it doesn’t. While tax-loss harvesting is often executed at year-end during tax planning, it must be implemented in accordance with IRS rules—most notably, the wash sale rule, which disallows a loss deduction if a substantially identical security is repurchased within 30 days of the sale. As such, it’s essential to approach this strategy with careful planning and regulatory awareness.
How Does Tax-Loss Harvesting Work?
What are the steps you need to follow for an effective tax-loss harvesting strategy? Here’s a standard approach many investors follow:
- Identifying Underperforming Investments: The first step is to assess which investments or assets are underperforming and have unrealized losses. It's prudent to consult with a tax advisor or financial professional to ensure alignment with your broader financial goals.
- Calculate Potential Tax Savings: Estimate the potential impact of realizing losses, considering both current-year capital gains and other tax liabilities. This assessment can help determine whether harvesting the loss is beneficial in the current tax year.
- Selling the Selected Investments: Execute the sale of the identified loss-generating investments. For illiquid assets, such as real estate or private placements, additional planning may be required. Consider how the transaction fits into your portfolio’s asset allocation and risk strategy.
- Reinvest Thoughtfully: If you still believe in the long-term value of the asset you sold, you may want to purchase a similar (but not “substantially identical”) investment to maintain your portfolio’s balance without violating IRS rules like the wash sale rule. We’ll discuss this rule further down.
- Record All Transactions: Proper documentation is still key. Not only does this practice help you keep track of each transaction, but these papers can be helpful if the IRS scrutinizes your tax-loss strategies.
- Report Tax Losses on Your Tax Return: Report your losses on your Form 8949 and Schedule D, making sure to offset capital gains and income tax with the value of the losses.
- Carryover Excess Losses: If your losses exceed the annual limit, then you can carry them over to the next year.
When to Consider Tax-Loss Harvesting
Technically, tax-loss harvesting can be done any time of year. However, many investors choose this strategy during year-end tax planning, typically in November and December. This allows investors to assess gains and losses across the entire calendar year before finalizing their tax strategy.
Harvesting losses mid-year can still be useful, especially in volatile markets. Doing so in the middle of the year spreads out decision-making, avoids rushed trades, and may offer more flexibility in reinvesting.
Rules and Concepts To Keep in Mind During Tax-Loss Harvesting
While the concept of tax-loss harvesting may seem simple in concept, the strategy involves several technical rules and regulatory considerations that must be carefully observed. Here are a few ideas to learn about and keep in mind.
Cost Basis
The cost basis of an asset—typically the original purchase price, adjusted for certain fees or improvements—is fundamental to determining capital gains or losses. For example, when you own the asset, the difference between the sale price and the cost basis determines whether you have a capital gain or loss.
Let’s say you bought a property a few years ago for $250,000. This is the cost basis. If you sold it for $230,000 two years later, then you realized a loss of $20,000. As such, cost basis becomes essential for identifying opportunities for tax-loss harvesting and ensuring accurate reporting.
Wash Sale Rule
If there is one critical rule that you should keep in mind, it’s the wash sale rule. This IRS regulation is meant to stop you from claiming a loss if you repurchase an asset that is the same or substantially identical to the one you just sold within 30 days before or after the sale. This rule prevents investors from generating artificial losses solely for tax benefits. While the loss cannot be deducted in the current year, it is not permanently disallowed—it is instead added to the cost basis of the repurchased security, effectively deferring the loss for future tax treatment.
For example, if you sell XYZ stock at a loss and buy the same stock again within 30 days, you cannot claim the loss for tax purposes. Instead, the disallowed loss is added to the cost basis of the newly purchased shares.
To avoid violating the wash sale rule, there are two things you can try. First, buy the asset or security at least 31 days before or after selling the underperforming asset. The second option is to buy an asset that is similar, but not substantially so, within the same market.
State-Specific Rules
The discussion we’ve had so far only applies at the federal level. Tax treatment at the state level can still vary. For example, states like California or New Jersey do not conform to all federal capital gain and loss rules. Others may not allow deductions for capital losses at all or have different limits. Given these differences, it’s important to consult with tax professionals who are familiar with the state rules where your asset is located. This consideration is especially significant for real estate assets.
Tax-Loss Harvesting Deadlines
To harvest losses for a given tax year, the sale of your losing or underperforming asset must be completed by December 31st of that year. Unlike contributions to IRAs or HSAs, which can be made after year-end for the prior year, capital gains and losses are based strictly on the calendar year in which the sale occurred.
This requirement adds another level of urgency, especially with how brokerages and other companies related to selling assets can experience delays at the end of the year.Reviewing your portfolio in November and, if appropriate, initiating tax-loss harvesting transactions by early December is generally considered a prudent timing strategy. This helps account for potential delays and ensures trades are settled by the year-end deadline.
Annual Deduction Limits for Ordinary Income
As we mentioned above, the IRS only allowed you to deduct up to $3,000 in net capital losses annually from your ordinary income. Even if you were able to realize a loss of $20,000, you’d still be left with $17,000 unaccounted for if no capital gains were offset first. Capital loss may be carried forward indefinitely. For example:
- Year 1: $20,000 – $3,000 = $17,000
- Year 2: $17,000 – $3,000 = $14,000, and so forth until…
- Year 6: $5,000 – $3,000 = $2,000
- Year 7: $2,000 – Final Deduction
Given these continued reductions, tax loss harvesting can become a multi-year tax management strategy for investors.
Offsetting Capital Gains With Losses
There are two types of capital gains that can be offset with tax loss harvesting.
- Short-term Capital Gains: This is the profit realized from assets held for less than a year. Short-term capital gains follow ordinary income tax rates.
- Long-term Capital Gains: Meanwhile, long-term capital gains are from assets or securities held for more than a year. These profits follow capital gains tax rates, with 20% as the highest bracket.
Losses are first applied to short-term gains, then to long-term gains. This prioritization is beneficial because it reduces the most heavily taxed gains first.
Example Scenario of Tax-Loss Harvesting
Let’s consider Mark, a real estate investor. He owns two apartment complexes, Building A and Building B. Due to a downturn in the local rental market and rising maintenance costs, Building A’s market value has dropped to $400,000 from $500,000. However, he recently sold Building B and realized $150,000 in capital gains.
To reduce his tax liability, Mark sells the underperforming apartment complex, realizing a $100,000 capital loss. He then uses that loss to offset part of the $150,000 gain from Building B’s sale. Thanks to tax loss harvesting, only $50,000 of his profit is subject to capital gains tax. The $3,000 deduction for ordinary income tax will not apply since Mark used all his capital losses to offset his capital gains tax.
To maintain investment exposure in real estate, Mark considers using the proceeds to purchase a different type of rental property, such as a small multifamily building in a stronger market. Since the wash sale rule does not apply to real property, he can reinvest without concern for that specific restriction, although broader tax and investment considerations still apply.
Advantages of Tax-Loss Harvesting
The main benefit, and the reason why investors employ tax-loss harvesting, is that the practice reduces tax liability. However, there are a few other advantages you can directly and indirectly enjoy from this strategy. Here are a few worth considering.
Offsetting Ordinary Income
If realized capital losses exceed capital gains, up to $3,000 ($1,500 if married filing separately) can be deducted against ordinary income annually, as permitted by the IRS. This is particularly beneficial in years with minimal realized gains. Unused losses may be carried forward indefinitely, allowing investors to potentially reduce future taxable income over time.
Portfolio Rebalancing
Tax-loss harvesting allows investors to rebalance portfolios while potentially mitigating the tax impact. For example, if your portfolio has drifted due to market movement, you can sell losing positions and use the proceeds to realign with your target asset allocation. Doing so allows you to correct risk imbalances while minimizing the tax impact.
Capital Gains Flexibility for Future Years
Unused capital losses can be carried forward indefinitely. As such, the remaining amount can become your buffer for future capital gains, especially if you’re considering selling assets that are highly appreciated or came from other tax-deferral strategies, such as 1031 exchanges. With your bank of losses, you can make more informed decisions when the time comes to sell valuable assets.
Strategic Tax Bracket Management
For high-net-worth individuals, tax-loss harvesting can be used to help stay within a desired tax bracket. Doing so can help you avoid net investment income tax (NIIT) thresholds. This is particularly useful for those who are managing a mix of ordinary income, investment income, and passive gains. Once you reach NIIT, you may face additional taxation that also depletes your overall cash flow.
Turning Volatility Into Opportunity
Market volatility can bring havoc to your investments and overall strategy, reducing the value of assets or creating scenarios that make securities underperform. You have no control over these fluctuations, but you can take a new perspective and view the losses as opportunities to reduce future tax liability. Plus, selling underperforming assets can provide liquidity to enter a similar sector or purchase an asset that may be more resilient to the current state of the market.
Potential Challenges and Pitfalls of Tax-loss Harvesting
Even with all the advantages you can expect from tax-loss harvesting, there are a few challenges and issues you must take into account. Being aware of these possible pitfalls helps you prepare for possible eventualities and protect yourself from increased tax liability.
Wash Sale Rule Violations
The IRS strictly imposes this rule because a wash sale is essentially a vehicle for artificial tax loss. An investor may be aware of this rule and wait for 31 days to pass as an extra precaution, but they can still unwittingly enter a wash sale through automated rebalancing tools or regularly scheduled purchases. When triggered, your capital loss may be disallowed for tax purposes, and the compromised sale may mess up your investment strategy for years to come.
Complex Documentation
Tax-loss harvesting adds layers of complexity to your investment records. You’ll need to track cost basis, acquisition dates, and loss carryforwards meticulously. This challenge becomes even more pronounced if you’re harvesting losses across multiple accounts or asset types. Without proper documentation, errors can creep into your tax filing or result in missed deductions.
Issues With Timing and Market Volatility
Poorly timed harvesting can lock in a loss just before the asset rebounds. If you sell during a temporary market dip and sit on the sidelines for too long to avoid the wash sale rule, you risk missing the recovery. This could lead to lower long-term returns, defeating the purpose of tax optimization.
Complications With State Tax
As we outlined above, not all states follow IRS rules on capital losses and gains. There are even some that don’t allow the carryover of losses on the state level. Some may apply different limits or treatments altogether. Given these variations, your tax-loss strategy must always be customized based on your (or the asset’s) state. This diligence helps you avoid unexpected tax liabilities at the state level and ensures that your overall tax-management strategy remains effective.
Limited Use of Losses
Capital losses can only offset capital gains and up to $3,000 of ordinary income per year. If your losses exceed your gains and you have little to no ordinary income to offset, those losses may take many years to use up. This issue is especially common in low-gain environments.
Fees and Advisory Costs
Given the complexity of tax loss harvesting, engaging with tax professionals and other financial experts becomes necessary to receive guidance and advice. These consultations and additional services they offer will result in fees. If the tax benefit doesn’t outweigh the advisory or transaction costs, the effort may be a net loss.
Strategic Situations for Tax-Loss Harvesting
Tax-loss harvesting won’t be the most sound strategy in certain situations. For example, if your capital gains are minimal or zero, the primary tax benefit may be limited to a $3,000 deduction on your ordinary income. This relatively small amount may not be worth the losses and additional expenses you’ll need to cover. However, there are plenty of scenarios where tax-loss harvesting becomes a key strategy for tax liability management. Here are a few.
- High-income Years: There may be a certain period when your personal income may be high thanks to bonuses, selling a business, or cashing out a profitable investment. During these moments, tax-loss harvesting may help offset realized capital gains and reduce adjusted gross income. The strategy may even help you avoid jumping into a higher tax bracket or avoiding the Net Investment Income Tax (NIIT).
- Market Downturns: During periods of broad market declines, investors may have more opportunities to realize losses without making drastic changes to their long-term investment strategy. However, like we said earlier, these events create opportunities to harvest losses without significantly disrupting your long-term investment strategy. You can sell an asset at a loss and purchase a similar (but not substantially identical) asset to maintain exposure while claiming a tax deduction.
- Portfolio Rebalancing: Tax-loss harvesting is also a good practice if you find that your portfolio has drifted from your intended allocation. With this tax management strategy, you can exit underperforming positions and help bring your portfolio back in line with your intended risk tolerance and long-term objectives.
- Retirement Tax Strategy: Within taxable investment accounts (non-IRA, non-401(k)), tax-loss harvesting may support a broader retirement income strategy by helping to reduce realized gains and thus preserve tax-advantaged compounding. It may also allow for more strategic liquidation planning across various account types and tax brackets in retirement.
Other Methods to Manage Tax Payments
Tax-loss harvesting is just one of the many strategies investors can use to manage tax liability. However, selling underperforming assets is not always the best approach. There is still a chance that the investment may rebound. For others, emotional attachment to the asset may prevent them from conducting a sale. Here are alternatives you can try.
1031 Exchanges
A strategy you can try is a 1031 exchange or like-kind swap. This is a tax-deferred strategy that allows you to exchange two properties without an official sale. Because gain recognition is deferred, a properly executed like-kind exchange allows you to postpone the capital gains tax that would otherwise apply to a sale. While 1031 exchanges do not eliminate capital gains taxes, they enable investors to reinvest the full proceeds from a sale into a replacement property, potentially enhancing capital preservation and long-term compounding.
Key IRS requirements include:
- Like-kind Property: You can only exchange real property with similar characteristics. In this case, similar means both must have been held for investment or business use. Primary residences are therefore not allowed for an exchange.
- 180-day Timeline: The entire exchange must happen within 180 days, with the first 45 days being dedicated to identifying replacement properties. Failure to meet the 45-day identification or 180-day closing deadlines can result in full recognition of the capital gain.
- Equal or Greater Value: The replacement property must have the same or greater FMV as the relinquished property. Any leftover cash will be considered boot, which is taxable.
Because these exchanges are irrevocable once initiated, it’s critical to work with qualified intermediaries and tax advisors to ensure proper execution and regulatory compliance.
Delaware Statutory Trusts
DSTs are an eligible vehicle for completing a 1031 exchange, allowing investors to acquire fractional interests in institutional-grade real estate. These passive investment structures are managed by professional sponsors and offer a hands-off approach to real estate ownership. DSTs are permissible under IRS Revenue Ruling 2004-86.
While DSTs offer passive ownership and access to professionally managed real estate, they also carry specific risks. Investors have no control over property management decisions, and DST interests are illiquid—meaning they cannot be easily sold or exchanged before the trust terminates. Additionally, distributions are not guaranteed and may fluctuate based on property performance and market conditions. DSTs also typically involve fees and sponsor-related expenses that can impact overall returns. As securities offerings, DST investments require careful due diligence and are generally suitable only for accredited investors with long-term investment horizons.
Deferred Sales Trusts
With the deferred sales trust, an investor sells an appreciated asset to a trust, which then sells it to a third party. The trust holds the proceeds and distributes payments to the seller over time, spreading the tax liability across multiple years.
Deferred Sales Trusts are complex structures that rely on interpretations of IRC §453, and they have not been explicitly reviewed or endorsed by the IRS. Improper structuring may result in the loss of tax deferral and potential penalties. These arrangements also involve legal, administrative, and advisory fees, which can reduce net proceeds. Moreover, the trust’s performance depends on investment decisions made with the held assets, which introduces market risk. Because of their complexity and regulatory scrutiny, DSTs should only be pursued with the guidance of qualified tax and legal professionals.
Charitable Remainder Trusts
For those who want to fulfill their philanthropic goals while still managing tax liability, a charitable remainder trust (CRT) is an option. This strategy allows you to move assets into the CRT, which then manages them to earn income. The income will then be distributed to you and your chosen charity, and only during these distributions will capital gains taxes be deducted. After your death, the assets will then be distributed to your chosen qualified charitable organizations.
While CRTs can provide income and support charitable objectives, they involve irrevocable transfers—once assets are contributed to the trust, they cannot be reclaimed. The trust’s investment performance directly impacts the income stream, which may fluctuate or fall short of expectations. Additionally, CRTs require careful tax and legal structuring to maintain compliance with IRS rules; failure to do so can jeopardize tax-exempt status and planned benefits.
Wrapping Up: Understanding the Basics of Tax-Loss Harvesting
Managing tax liability is a critical component of investment strategy, particularly after realizing gains from highly appreciated assets. Tax-loss harvesting offers a structured method for offsetting capital gains by realizing losses on underperforming investments. By selling your underperforming assets and using the capital losses to reduce your capital gains income, you reduce your overall tax payments. Plus, there’s also the $3,000 deduction (or $1,500 if married filing separately) on your ordinary income.
Tax-loss harvesting can be complex, and there are other considerations to keep in mind, such as the wash sale rule. As such, it’s always good practice to consult with tax professionals and other experts to gain the necessary resources and guidance.
The tax and estate planning information offered by the advisor is general in nature. It is provided for informational purposes only and should not be construed as legal or tax advice. Always consult an attorney or tax professional regarding your specific legal or tax situation.
Article written by: Story Amplify. Story Amplify is a marketing agency that offers services such as copywriting across industries, including financial services, real estate investment services, and miscellaneous small businesses.
Sources:
https://www.investopedia.com/terms/t/taxgainlossharvesting.asp
https://www.investopedia.com/terms/c/capital-loss-carryover.asp
https://www.irs.gov/forms-pubs/about-form-8949
