More on Tax-Loss Harvesting

Note: The idea of tax-loss harvesting applies only to taxable accounts. This idea does not apply to tax-deferred accounts such as 401(k)s, TSPs, IRAs, or similar.

Recently, I wrote an article about the down market. At the time, domestic stocks were down anywhere from 3% to 10% year-to-date depending on the index of choice. Since then, we’ve seen a few more days exceeding a 1% loss. Needless to say, it hasn’t been a good start to the year.

Despite this rough start, I wanted to write about the silver linings of a down market. More specifically, I wanted to focus on the few positive ideas or actions we could take when stock prices fall. These ideas are important because market downturns can happen often and be very unpredictable. During those times it’s critical we keep our heads straight and understand how to navigate the volatile environment. A positive perspective can help.

Read more about how to find joy in the down market here.

Perspective and action

Many of the ideas discussed in the article were meant to inspire calm and build perspective. These ideas were market resiliency, dollar-cost averaging, and the low cost of buying/conversions. Of these, dollar-cost averaging is probably the most popular with many individuals already making regular deposits into their retirement accounts. The others require a little more introspection and care, but what about taking direct action?

As it turns out, there are tactics you can deploy in a down market. Some of the ideas above could be actionable should you choose to time them advantageously, but there is one idea that is designed specifically to flourish in a down market. That idea is tax-loss harvesting.

A few concepts

Before diving into tax-loss harvesting, I would like to take a moment to go over a few key ideas. These ideas are important to understand. If you already know these terms, feel free to skip ahead.

1) Cost basis: This is the price you paid for something. If you buy a stock for $10, your cost basis is $10. The stock may rise or fall in price, but your cost basis remains $10.

2) Capital gains: If you sell a stock for more than your cost basis, you must pay capital gains on the profit. For instance, if your cost basis is $10 and you sell the stock for $15, you must pay capital gains tax on $5. Tax rates depend on how long you hold the stock (see below). It’s important to remember you don’t have to pay any tax on the cost basis portion since you’re recovering your initial investment amount.

3) Short-term capital gains tax: If you hold a stock for a year or less, any gain above cost basis will be taxed as short-term capital gains. Short-term capital gains tax is equal to the amount you pay on income, aka your marginal tax bracket.

4) Long-term capital gains tax: If you hold the stock for longer than a year, any gain above cost basis will be taxed as long-term capital gain. Long-term capital gains are taxed at much more attractive rates of 0%, 15%, and 20% with the vast majority of taxpayers falling within the 0% and 15% brackets.

5) Capital loss: If you sell a stock for less than your cost basis, you experience a capital loss. The amount of loss is simply your cost basis minus the price you sold for.

Tax-loss harvesting

If you discover a stock or mutual fund is selling less than your cost basis, you have an opportunity to execute tax-loss harvesting. That is, you can sell the stock at a loss and report that loss on your income taxes. The beauty of this is the loss can offset multiple types of taxes, making it a very versatile way to lower taxes. Here's how it can help:

* Capital losses can offset either short or long-term gains. When aggregating your gains and losses each year, you begin by offsetting short-term gains and losses together, then long-term gains and losses. If you’re left with losses of one type and gains of another, you then offset them against each other again. Yes, that means capital losses can offset short OR long-term gains no matter how long you held the stock before selling it for a loss!

* Leftover capital losses can offset income. If you have capital losses leftover after offsetting all the long and short-term gains and losses, you can even offset regular income. There are limits (up to $3,000 a year), but losses can be carried forward indefinitely.

Maximizing tax-loss harvesting

Ideally, this technique should be used in years that you don’t expect long-term capital gains. The greatest advantage of tax-loss harvesting is its ability to offset short-term gains or income (both taxed at your marginal tax rate). If you can, avoid netting losses against long-term gains as much as possible.

It isn’t all roses

You may wonder why the IRS so lenient on how capital losses can be used? Why do they allow losses to offset long-term capital gains, short-term capital gains, AND income? Remember, the amount of loss you experience in a capital loss is against the original cost basis. When you purchased the stock, you probably used money you earned as income and already paid income tax on. Therefore, losing any amount of that basis just to offset low long-term rates is a good deal for the IRS (and a bad deal for you). Especially if you are a married couple earning less than $94,050 a year (2025). That would mean you’re using losses you paid income tax on to offset long-term capital gains that would have been 0%.

Confused yet? Reach out for a no obligation meeting.

You sold at a loss, now what?

If you decide to proceed with tax-loss harvesting, you have another issue to consider: what do I buy? That is, once you sell stock at a loss, you then need to buy something else or leave the payout in cash. If you liked the stock or mutual fund you sold at a loss, you may think you can go ahead and repurchase it after the dust settles. As it turns out, the IRS has a rule about this. It’s called the wash rule.

The wash rule states that any capital loss is null if the sale is preceded by or followed by the purchase of the same stock or substantially identical stock within 30 days. Yes, that means you can’t purchase the same stock within 30 days prior to or after the sale at a loss. If you do, then the loss sale is not allowed and complicated math follows to establish cost basis.

The category “substantially identical” is a vague standard but typically refers to different types of stock classes or convertible bonds/assets issued by the same corporation. For mutual funds, buying a similar fund (even tracking the same index) can usually avoid this rule if the fund is managed by a different investment company. Please consult a financial professional for specific situations.

Resetting cost basis

Once you decide to execute tax-loss harvesting, it’s important to understand that you are simply resetting your cost basis. It’s not a terrible thing, just an important perspective to keep in mind.

For example, let’s say you purchase $10 of a S&P index fund. You then sell the fund for $8, reporting a loss of $2. You then purchase $8 of a different S&P index fund and avoid the wash rule. Good job, you executed tax-loss harvesting and can report the $2 loss on your taxes.

It’s important to remember you simply lowered your cost basis from $10 to $8. Yes, you got a tax break in the meantime, but should you sell again at a gain within a year, the loss is offset by short-term gain of the same amount. Keep these things in mind to avoid performing these actions, only to end up running in circles.