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Key Takeaways

  • You can use realized losses to offset realized gains and/or reduce up-to $3,000 of earned income in a tax year.

  • Knowing the holding period of your investments is very important. Short- term gains have the potential to double your tax liability compared to long-term gains.

  • Capital losses may be carried forward to future tax years, which can help offset expected and unexpected capital gains.

Tax loss harvesting is a common tax strategy in non-retirement accounts. For the strategy to work, securities are sold at a loss to realize short- or long-term capital losses. The losses realized in the transaction can be used to offset realized capital gains and/or reduce up-to $3,000 of earned income.

There are two types of gains and losses, short-term and long-term. The holding period will determine the gain or loss. A holding period of one year or less will result in a short-term gain or loss. More than a year is a long-term gain or loss.

The biggest differentiator between short- and long-term capital gains is how they’re taxed. Short term gains are taxed at ordinary income tax rates. Long-term gains are taxed at 0, 15, or 20 percent, depending on your taxable income.

short term gains are taxed at ordinary income rates. Long term gains are taxed at 0%, 15%, or 20%. Short-term and long-term losses can offset gains and up to $3,000 of earned income

* Losses realized can be used to offset realized gains and/or reduce up-to $3,000 of earned income

The chart below clarifies who pays 0, 15, or 20 percent on long-term capital gains.

Long-term capital gain rates for each filing status based on taxable income for 2019.
Source: TheTaxBook – 2019 Tax Year

Many Investors will try to minimize short-term gains to avoid paying taxes at their ordinary-income rate. To achieve this, they can delay selling an investment until the gains are long-term or through tax-loss harvesting.

Example: Fred and Molly had a household income of $550,000 in 2019. Needing money from their brokerage account, they are trying to determine their potential tax liabilities.  They’ve owned their assets for just over eleven months. When they sell their assets, they will realize a $137,000 gain. The image below shows their hypothetical tax picture if they were to sell now versus waiting a month.

A flow chart to show how $137,000 in capital gains are taxed as short-term or long-term gains.

If they sell before the one-year holding period, they will realize a $137,000 short-term capital gain, resulting in a $50,690 tax bill. If they wait one month, their tax bill is nearly cut in half.

A slightly different scenario. Fred and Molly have the same income, but their money has been invested for a decade. They need $250,000 for a down payment on a vacation home and sold four positions in their brokerage account. In their account, they had:

  • 1 stock with a short-term gain

  • 1 stock with a long-term gain

  • 1 stock with a long-term loss

  • 1 stock with a short-term loss

Through tax-loss harvesting, Fred and Molly avoid having to pay capital gain taxes on the sales. The kicker is that the excess losses can reduce their income by $3,000 or be carry-forward to next year.

A chart showing how tax loss harvesting can take short-term and long-term losses to offset short-term and long-term gains. With net losses, up to $3,000 of losses can offset earned income.

Another tax-loss harvesting strategy is selling positions for the sole purpose of capturing losses. This is often a strategy used in a down market. In this scenario, an investor sells ‘ABC’ stock to realize a short- or long-term loss. Then, they purchase ‘XYZ’ stock to avoid missing the potential upside in a recovering market. Before placing the subsequent buy, the investor was sure to avoid the Wash Sale rule.

The Wash Sale rule exists to prevent taxpayers from shuffling papers to generate a deductible loss, e.g., selling a position today and repurchasing it tomorrow. Therefore, A Wash Sale occurs when an investor sells a position at a loss and within 30-days;

  • Buys substantially identical stock or securities,

  • Acquires substantially identical stock or securities in a fully taxable trade,

  • Acquires a contract or option to buy substantially identical stock or securities, or

  • Buys substantially identical stock or securities in an individual retirement account (IRA) or Roth IRA

If any of the above scenarios occur, the loss in the transaction is disallowed.

With the many nuances involved in tax-loss harvesting and our tax code’s complexity, working with a financial advisor and tax professional before implementing a tax-loss harvesting strategy is highly recommended.