Turning Market Losses into Tax Wins with Tax Loss Harvesting
- Caitlin Muldoon
- 7 days ago
- 9 min read
It’s hard to see the silver lining during market tumbles- especially if we’re checking our portfolios a little too often. Fortunately, there are some opportunities we have (aside from "buying the dip”) during market downturns, and one of those is tax-loss harvesting. Tax-loss harvesting is when you sell investments that have dropped in value to offset the taxes you’ll have on the investments that have gained value. Most investors turn around and buy back similar assets to the ones they’ve sold for a loss, so that they’re not actually losing out on shares- they’re creating paper losses in their portfolios, which can then be used to offset taxes on other gains in the portfolio, and can even be used to reduce ordinary income taxes. Here are ways that everyday investors can take advantage of tax-loss harvesting:
Use the losses in your portfolio to cancel out the capital gains from your winning investments in the same tax year
Save those losses for future years when you’ll have gains to offset
Reduce your ordinary income by up to $3,000 each year
This isn't just about cutting your losses- it's a smart way to improve what you actually keep after taxes. Luckily, with today's investment platforms and robo-advisors, it's much easier to take advantage of this strategy. So, let’s dive into this details of how it works!
The Nuts and Bolts: How Tax-Loss Harvesting Actually Works
Ever wonder how the mechanics of tax-loss harvesting actually play out in your portfolio? In light of this springtime bear market, let's break it down with some gardening metaphors :)
The Balance of Gains and Losses
At its heart, tax-loss harvesting is about strategically using the bad news in your portfolio to offset the good news on your tax return. Here's what you need to know:
Capital gain: The profit when you sell something for more than you paid
Capital loss: The loss when you sell something for less than you paid
Cost basis: What you originally paid for an investment (this is super important!)
The cost basis of an asset, compared to the asset’s value when you sell it, determines whether you have a capital gain or loss. The reason this is important is because we pay taxes on our gains, while our losses can offset our gains, thereby lowering our taxes. Let’s say you bought Stock A for $10,000, but today it's worth only $5,000—ouch! Meanwhile, Stock B that you bought for $5,000 is now worth $8,000—nice!
If you sell both:
You have a $5,000 loss from Stock A (this is your capital loss, because today’s value of Stock A is less than its cost basis)
You have a $3,000 gain from Stock B (this is your capital gain, because today’s value of Stock B is greater than its cost basis)
Remember you pay taxes on gains. So, you’d have a tax liability from the sale of Stock B since Stock B gained $3,000 in value since you purchased it. But- the $5,000 loss from Stock A completely wipes out the tax on your $3,000 Stock B gain, plus you can use the remaining $2,000 loss to reduce your regular income taxes (the IRS allows up to $3,000 of losses to be used to reduce ordinary income tax each year). Here’s one more kicker: rather than wiping out the number of shares in Stock A from your portfolio completely, you can use the losses of Stock A to buy shares that are similar. Let’s say Stock C tracks the same index that Stock A did. You can use the value of the Stock A shares that you sold for a loss to buy the same amount of Stock C shares. Now your portfolio hasn’t felt the loss of Stock A, since it’s been recouped now with the same number of shares in Stock C. But you still are able to take advantage of your losses from Stock A. Win!
Your 4-Step Garden Plan for Tax-Loss Harvesting
Cultivate - Look through your portfolio for any assets that have gone down in value since you bought them.
Prune - Cut those under-performers by selling them, which "realizes" the loss so you can use it for tax purposes.
Harvest - Use those losses to offset your gains from other investments. If your losses exceed your gains, you can even reduce your ordinary income by up to $3,000.
Replant - Put that money back to work by buying something similar (but not identical) to maintain your investment strategy.
Timing Your Harvest
While many investors wait until December to do their tax-loss harvesting (like cramming for a final exam!), that might not be the smartest approach. Market corrections throughout the year can offer perfect opportunities to harvest losses. As of the time of this writing, we are witnessing a bear market, which is reflecting most assets in the US stock market to be at a significant loss. During this market dip, you can lock in losses while keeping your portfolio properly balanced across different types of investments. Waiting until December may mean these assets won’t have the same loss as they do now.
Understanding Your Cost Basis
Getting your cost basis right is crucial - it's like measuring from the right starting point. If you get this wrong, you might report incorrect gains or losses and potentially face penalties from the IRS.
QUICK TIP: Remember, a loss only counts when you actually sell the investment. Just watching your portfolio value drop doesn't create a tax-deductible loss!
Short-Term vs. Long-Term: Know the Difference!
Here's where strategic thinking really pays off:
Short-term gains (held ≤ 1 year): Taxed at your regular income rate (up to 37%!)
Long-term gains (held > 1 year): Taxed at much lower rates (0%, 15%, or 20%)
This is why it makes the most sense to use your short-term losses to offset short-term gains first - you're neutralizing your highest-taxed gains!
Remember, tax-loss harvesting isn't just about cutting losses - it's about being strategic with WHEN and HOW you recognize them for tax purposes!
The Fine Print About Tax-Loss Harvesting
Kicking the Tax Can Down the Road
Let's be clear about something - tax-loss harvesting doesn't make your taxes disappear like magic. It's more like pushing your tax bill into the future. You're resetting your cost basis to a lower level, which means potentially higher capital gains taxes later.
But here's where it gets interesting - this is actually a form of "tax arbitrage." You can deduct up to $3,000 against your ordinary income now (which might be taxed at rates as high as 37%), and then when you eventually sell those replacement investments, you'll likely pay the much lower capital gains rates (0%, 15%, or 20%).
When This Strategy Really Shines
Tax-loss harvesting makes the most sense if:
You expect to be in a lower tax bracket in the future
You're planning to donate those securities to charity
You might hold them until death, giving your heirs that sweet stepped-up cost basis
Don't Miss the December 31 Deadline!
Here's a crucial difference from other tax strategies: While you can fund your IRA until April for the previous tax year, tax-loss harvesting has a firm December 31 deadline. This is why you often see increased selling activity during the holiday season - it's not just people funding their Christmas shopping!
Know Your Limits (And How to Use Them)
There's no limit to how many capital gains you can offset with losses. And if your losses exceed your gains, you can deduct up to $3,000 against your ordinary income ($1,500 if married filing separately).
Even better - any unused losses don't expire. You can carry them forward indefinitely to future tax years. It's like having a tax-savings account you can tap into when needed.
One thing worth pointing out, which differs from a lot of other tax loopholes, is that there's no bonus for married couples filing jointly - the $3,000 deduction limit is the same whether you're single or filing with your spouse.
Also worth noting: Your stock losses can offset gains from selling real estate or even a business - they're not limited to just offsetting other stock market gains!
Watch Those Fees
Don't forget to factor in brokerage fees and bid-ask spreads when executing your tax-loss harvesting trades. These costs can eat into your tax savings if you're not careful.
The good news is that many robo-advisors now offer automated tax-loss harvesting, making this once-complicated strategy much more accessible to everyday investors.
IMPORTANT: The Wash Sale Rule
This is the big one that trips people up: The IRS doesn't want you selling something just for the tax benefit and then immediately buying it back. That's why they created the "wash sale rule" - you can't claim a loss if you buy the same or a "substantially identical" security within 30 days before or after selling.
Don't try to be clever about it! This rule applies across ALL your accounts - including IRAs and even your spouse's accounts if you file jointly. The IRS is watching for a full 60-day window (30 days before and 30 days after your sale).
Dividend re-investing can also trigger the wash sale rule. If you’ve sold an asset for a loss, but had dividends from that asset that were re-invested within that 30/30 window of the sale, this too will trigger a wash sale. Therefore- make sure that any dividends from the asset you’re selling are not paying out within the 30/30 window of your sale. If they are, be sure NOT to reinvest those dividends in that asset, otherwise you will trigger a wash sale.
Even employee stock purchase plans and vesting stock bonuses can accidentally trigger this rule if you're not careful with your timing.
The key is to maintain your investment strategy by buying something similar but not identical, or simply waiting out the 30-day period!
Tax-Loss Harvesting in 10 Steps
Thinking about trying tax-loss harvesting but not sure where to start? I've broken it down into 10 simple steps:
1. Take a Portfolio Inventory
Regularly check your investments to spot the underperformers. Look for anything that's worth less now than when you bought it—these are your potential tax-saving opportunities!
2. Do the Math Before You Act
Before selling anything, run some quick calculations to see if it's worth it. How much could you save in taxes by realizing these losses? Sometimes a small loss isn't worth the transaction costs.
3. Pull the Trigger on Losers (Strategically!)
When you're ready, sell those underperforming investments. But don't just sell because something's down—make sure this fits with your overall investment strategy.
4. Put That Money Back to Work—Quickly!
Don't let the proceeds sit in cash! Immediately buy something similar (but not identical) to maintain your investment strategy. Remember, you're not trying to time the market—you're just using the tax code to your advantage while staying invested.
5. Don't Trip Over the Wash Sale Rule
This is critical! Make absolutely sure you don't buy the same or a "substantially identical" investment within that 30-day window before or after your sale. This applies across ALL your accounts and even your spouse's if you file jointly.
6. Keep Meticulous Records
Document everything: purchase dates, sale dates, prices, and cost basis information. Good record-keeping will save you headaches at tax time and could save you money if you're ever audited.
7. Tax Time: Report Everything Properly
When filing your taxes, carefully report all your realized gains and losses on Form 8949 and Schedule D. Missing something here could cost you the tax benefits you worked for!
8. Don't Forget Your Loss Carryforwards
If you couldn't use all your losses this year, keep track of them! Those excess losses can be carried forward indefinitely to future tax years—they're like a tax-saving account you can tap into later.
9. Get Professional Help When Needed
Tax rules can get complicated. Working with a financial advisor or tax professional can help ensure you're maximizing your benefits while staying compliant with all IRS rules.
10. Stay Flexible and Review Regularly
As your financial situation changes, tax laws evolve, or markets shift, be ready to adjust your strategy. What worked well this year might need tweaking next year.
Remember, tax-loss harvesting isn't a one-time event but an ongoing strategy that can add significant value to your investment portfolio over time. With careful planning and execution, you can turn market downturns into tax advantages!
The Fine Print
This strategy doesn't make taxes disappear forever—it's more like pressing the pause button. The tax you save today can be reinvested and grow over time, potentially outweighing the future tax bill.
Remember—it's not about avoiding taxes completely, but about being strategic with when and how you pay them!
WORD OF CAUTION: While tax-loss harvesting can be beneficial, it's not one-size-fits-all. It should be part of your broader financial strategy, and given some of the complexities involved, checking with a tax professional is always a smart move before diving in. Information in this article is not investing or tax advice. Contact a financial professional before making decisions about your investments.
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