2026 Tax season will be here before you know it: An Introduction to Tax-Loss Harvesting
Seeing an investment portfolio dip into the red is never an enjoyable experience. But in the world of long-term investing, market fluctuations are a given. While market downturns can be unsettling, they can also present opportunities for strategic financial planning. One such strategy is known as tax-loss harvesting.
It might sound complex, but the concept is fairly straightforward. It’s a method of potentially turning a market loss into a tangible tax benefit, without fundamentally altering your long-term investment strategy. This post will walk you through the mechanics of how it works for educational purposes.
What is Tax-Loss Harvesting?
At its core, tax-loss harvesting is the practice of selling an investment in a taxable brokerage account that has decreased in value. The purpose of selling isn't to get out of the market, but to intentionally "realize" a capital loss.
As long as you hold an investment, any loss is simply "on paper" and has no tax consequences. It's only when you sell the asset that the loss becomes realized, and at that point, it can be used to potentially lower your tax bill.
How the Losses Can Be Used
Once you’ve realized a capital loss, the IRS allows you to use it in a specific, prioritized order:
Offset Capital Gains: First and foremost, the realized losses are used to cancel out any realized capital gains you may have elsewhere in your portfolio. For instance, if you sold one stock for a $5,000 gain and another for a $5,000 loss in the same year, the two would offset each other, and you would owe no capital gains tax on that transaction. Losses first offset gains of the same type (short-term vs. long-term) before being applied to the other.
Deduct Against Ordinary Income: If your realized losses are greater than your realized gains for the year, you can use the excess loss to lower your ordinary taxable income. There is an annual limit to this deduction, which is currently $3,000 per year for those filing as single or married filing jointly. This is a direct deduction that can lower your overall tax burden from sources like your salary.
Carry Losses Forward: What if your net capital loss for the year is more than $3,000? Any remaining loss isn't gone for good. It can be carried forward to future tax years. In the following year, you would again use those carried-over losses to first offset any capital gains, then deduct up to $3,000 against ordinary income, and carry forward the rest. This process can continue indefinitely.
The Most Important Rule: The "Wash Sale"
This strategy comes with a critical rule from the IRS: the Wash Sale Rule.
This rule prevents you from selling a security at a loss and then immediately buying it back. Specifically, you cannot claim a tax loss if you purchase the same or a "substantially identical" security within 30 days before or 30 days after the sale. This creates a 61-day window to watch out for.
The purpose of the rule is to stop investors from claiming a tax break without genuinely altering their investment position. If you violate the wash sale rule, the loss is disallowed for tax purposes for that year.
To navigate this, a common practice during tax-loss harvesting is to sell a losing investment and then immediately use the proceeds to buy a similar, but not substantially identical, investment. For example, one might sell an S&P 500 ETF from one provider and purchase an S&P 500 ETF from a different provider. This allows an investor to maintain their desired market exposure while still successfully "harvesting" the loss.
A Final Thought
As we approach the end of the year, tax-loss harvesting is a disciplined tool for managing tax liability within a long-term investment plan; it is not a market-timing strategy. It’s important to note that this strategy only applies to taxable investment accounts, not tax-advantaged retirement accounts like IRAs or 401(k)s where capital gains and losses are not taxed annually.
This article is for informational purposes only. Tax-loss harvesting is a complex strategy with specific rules, and it may not be suitable for everyone. We strongly encourage you to consult with a qualified financial advisor and tax professional to determine if any investment or tax strategy is appropriate for your individual situation.