Investment Fundamentals: Tax-Loss Harvesting

September 3, 2014

The process of selling a security at a lower price than initially purchased to offset taxable gains

At-a-glance summary:

  • Tax-loss harvesting is the process of selling a security at a lower price than initially purchased to offset taxable gains.
  • Effective execution of a tax-loss harvesting strategy can increase the after-tax value of an investor’s portfolio.
  • The wash-sale rule prohibits re-purchasing the same security, or one that is substantially identical, within 30 days of sale for the purpose of realizing a capital loss.

Tax-loss harvesting is the process of selling a security at a lower price than initially purchased in order to offset taxable gains in other areas of the portfolio. 

Consider a case in which an investor places $10,000 in each of two securities, Winner and Loser, at the beginning of the year. If, at year-end, Winner has increased in value to $12,000 and the investor wishes to sell that security, then the investor would be subject to taxes on the $2,000 earned during the year. If the tax rate is 40%, $1,200 would make its way to the investor’s pockets while $800 would be due in taxes. 

Tax-loss harvesting is the process of selling a security at a lower price than initially purchased in order to offset taxable gains in other areas of the portfolio.

Imagine now that the other security, Loser, has simultaneously declined in value to $9,000. If the investor chooses to sell that security as well, the capital loss of $1,000 from Loser can be used to offset part of the $2,000 gain from Winner. In this example, the investor has only $1,000 in capital gains for the year rather than the original $2,000, resulting in only $400 of taxes rather than the original $800 owed if Loser had not been sold. Not only has the investor generated a positive return on the original portfolio, but the additional $400 saved from tax-loss harvesting can be reinvested in markets rather than used to pay taxes. 

Furthermore, current tax law allows investors to use $3,000 of capital losses annually to offset any form of income, not just the amount derived from capital gains. Factor in that harvested losses can also be carried forward indefinitely to offset future gains or income, and tax-loss harvesting becomes a valuable tool to improve an investor’s after-tax portfolio return. 

Adhering to the wash-sale rule

Harvesting losses can be a terrific strategy, but proper execution is no easy task. In the previous example, the investor succeeded in eliminating current tax liability by selling Loser, but has also eliminated market exposure (because both securities were sold). What if the investor wanted to harvest losses but remain invested in markets? 

When selling a security to harvest a loss, it is necessary to reinvest the proceeds in a different security that is not substantially identical.

The wash-sale rule prohibits re-purchasing the same security, or one that is substantially identical, within 30 days of sale for the purpose of realizing a capital loss. 

For example, selling a mutual fund that tracks the S&P 500 and buying another from a different provider that also tracks the S&P 500 would likely violate the wash-sale rule as the two funds are substantially identical. 

When selling a security to harvest a loss, it is necessary to reinvest the proceeds in a different security that is not substantially identical.

One traditional method for satisfying this rule consists of replacing individual stocks or mutual funds with others that exhibit similar characteristics in order to maintain exposure. A common example would be selling the stock in one large bank and using the proceeds to buy stock in another large bank, with the expectation of those securities tracking each other closely. Selling a mutual fund that tracks the S&P 500 and buying another that tracks a different index, such as the Russell 1000, would generally not violate the wash-sale rule even though both provide exposure to large-cap U.S. stocks.

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Legal Note

Information provided by SEI Investments Management Corporation (SIMC), a wholly owned subsidiary of SEI.
This information should not be relied upon by the reader as research or investment advice, nor should it be construed as a recommendation to purchase or sell a security. There are risks involved with investing, including loss of principal. Bonds and bond funds will decrease in value as interest rates rise. Neither SEI nor its affiliates provide tax advice. Please note that (i) any discussion of U.S. tax matters contained in this communication cannot be used by you for the purpose of avoiding tax penalties; (ii) this communication was written to support the promotion or marketing of the matters addressed herein: and (iii) you should seek advice based on your particular circumstances from an independent tax advisor.