Tax-Loss Harvesting Cheat Sheet

What is Tax-Loss Harvesting?

Tax-loss harvesting is a strategy to lower your investment taxes. It involves selling an investment that has lost value, and then using that loss to reduce your taxable capital gains. This can also offset up to $3,000 of your ordinary income per year.

The 4-Step Process

Step 1: Identify a Loss

Look for an investment (stock, ETF, mutual fund) in a taxable brokerage account that is currently worth less than you paid for it. This strategy does not apply to tax-advantaged accounts like 401(k)s or IRAs.

Step 2: Sell the Investment

Sell the asset to “realize” the capital loss. The loss is the difference between your selling price and your cost basis (what you paid for it).

Step 3: Use the Loss to Offset Gains

When you file your taxes, the realized losses are first used to offset any realized capital gains from the same year.

Short-term losses offset short-term gains first.
Long-term losses offset long-term gains first.
Any remaining losses can then offset gains of the other type.

If you have more losses than gains, you can use up to $3,000 of the excess loss to reduce your ordinary income (like your salary), which is taxed at a higher rate.

Step 4: Reinvest the Money (and Avoid a Wash Sale)

Immediately reinvest the cash from the sale into a different but similar investment. This keeps your money in the market, maintaining your desired asset allocation.

CRITICAL: You must not buy a “substantially identical” security 30 days before or after the sale. Doing so triggers the Wash Sale Rule, and the tax loss will be disallowed.

The Wash Sale Rule Explained

Warning: The Wash Sale Rule

The IRS will disallow your tax loss if you buy a “substantially identical” security within 30 days before or after selling the original security for a loss. This 61-day window is critical.

What is “Substantially Identical”? The IRS does not give a perfect definition, but it’s generally interpreted as:
- The same stock (e.g., selling AAPL and buying AAPL).
- Options or contracts to buy the same stock.
- Mutual funds or ETFs that track the same index (e.g., selling one S&P 500 index fund and buying another).
How to Avoid It: Sell a security and buy one that is similar but not identical.
- Example: Sell an S&P 500 index fund and buy a Total Stock Market index fund.
- Example: Sell Coca-Cola (KO) and buy PepsiCo (PEP).

Example Scenario

You invested $10,000 in ETF A.
The market dips, and your investment is now worth $7,000.
You also sold ETF B this year for a $5,000 capital gain.

The Strategy in Action:

You sell ETF A to realize a $3,000 capital loss.
This $3,000 loss offsets your$ 5,000 gain from ETF B.
Your net taxable capital gain is now only ** $2,000** ($ 5,000 - $3,000).
You immediately reinvest the $7,000 from the sale of ETF A into ETF C, which has a similar investment profile but is not substantially identical, keeping your market exposure.

Key Takeaways

Only for Taxable Accounts: This strategy is irrelevant for IRAs, 401(k)s, etc.
$3,000 Annual Income Deduction: This is a powerful benefit if your losses exceed your gains.
Beware the Wash Sale Rule: This is the most common mistake. When in doubt, choose a replacement investment that is clearly different.
It’s about Tax Deferral: Tax-loss harvesting defers your tax liability. When you eventually sell the replacement investment, your cost basis will be lower, potentially leading to a larger taxable gain in the future. However, deferring taxes is almost always advantageous.