How to "Profit" From Losing Investments

As the year comes to a close, lots of opportunities exist for families to make final decisions that can affect their finances and their taxes. These include Traditional or Roth IRA contributions, HSA contributions, year-end expenses for farmers, ranchers, and business owners, just to name a few.

Another lesser known year-end strategy is something called tax loss harvesting. This strategy helps investors take advantage of investment losses they may have experienced, but still keep their funds invested for the long-term.

WHAT IS TAX LOSS HARVESTING?

When you tax loss harvest, you sell investments that have lost value from their original purchase price, and subsequently buy a different or similar investment, but not identical investment, immediately, or the same investment at least 31 days later. Tax loss harvesting can only be done in taxable brokerage accounts, not retirement accounts.

This advice runs contrary to the typical advice of “buy low, sell high” so why do it? 

By selling the losing investment, you’re “harvesting” the losses that investment has experienced. In the IRS’s eyes, you can use your investment gains and investment losses to your advantage. By capturing the losses, the IRS allows investors to apply those losses to investment gains–gains that would otherwise be taxed. 

Example: Jeff has a brokerage account where he likes to invest in individual stocks. In 2022, Jeff experienced a significant loss in one of his stock investments he’s held for several years. The investment was purchased for $10,000 and now has a value of $3,000 in 2023. To take advantage of tax loss harvesting, Jeff could sell this investment, for which he would receive $3,000. He would now have a loss of $7,000. Jeff has another stock investment that has done very well, but he’s no longer interested in keeping it. This investment was also purchased for $10,000 and now has a value of $13,000. Jeff could also sell this investment, but instead of owing capital gains taxes on the $3,000 gain, he can completely offset those gains using the losses from his first investment, wiping out any taxes owed on the gain.

THE TAX IMPACT OF TAX LOSS HARVESTING

Any unused losses can be carried over year after year by the investor for an indefinite period of time. Up to $3,000 of these losses can also be used to reduce one’s personal income on their taxes each year, until the carried over losses run out.

Example (continued from above): Jeff now has $4,000 of losses that he can apply elsewhere. There are a couple of things Jeff can do before year end. First, if Jeff has other investments that he’d like to sell for a gain, he can further offset those gains using his losses. Second, if Jeff has no other investments he’d like to sell, come tax season next year he could take $3,000 of the $4,000 remaining loss and apply it as a reduction to his income. He would have $1,000 remaining that could be carried over to subsequent years until used.

Below is a hypothetical illustration of Jeff’s 2023 tax return. Notice the capital loss of $3,000 on Line 7. This loss reduces his total income by this amount. If we assume Jeff is at the 12% marginal tax rate, this $3,000 loss reduces his taxes by about $360.

Harvesting this loss has allowed Jeff to “profit” through two tax reductions. First, his capital gains taxes were eliminated because of the losing investment offsetting his other investments’ gains, and second, his income taxes were reduced by applying part of the loss against his income.

A TAX LOSS HARVESTING PITFALL

There is at least one limitation to be aware of with tax loss harvesting. To prevent investors from simply capturing losses on investments they plan to hold on to for a long time and immediately buying back the identical investment, the IRS implemented the 30-day wash sale rule. 

An investor that still believes in the growth potential of the stock he sold can avoid the wash sale rule by waiting at least 31 days or more to purchase the same investment. 

If the wash sale rule is violated, meaning the identical investment is purchased within the 30-day window, then any investment losses generated from the sale of that investment are not allowed to offset any investment gains. 

Example: Jeff, unaware of the wash sale rule, sells some stock at a loss and immediately buys back the identical stock two days later. Jeff then applies this investment loss to some other investment gains he’s experienced in the year. Because Jeff violated the wash sale rule, he will be unable to apply this investment loss on his investment gains. Unless Jeff has other, legitimate losses that have been captured, he will be unable to offset his investment gains and will owe capital gains taxes on the sale.

SUMMARY

As an investor, you’re a participant in the successes and failures of the companies you invest in. Just like other investments, like a small business and real estate, certain losses can be used to offset certain gains. 

Tax loss harvesting is the way for investors to do this. It allows investors to capture investment losses to offset investment gains, and other securities can be purchased immediately, or the identical security as long as you’re past the 30-day wash sale rule. Investors would be wise to identify any losses that may exist in their investment portfolios, and consider taking advantage of tax loss harvesting before the end of the year.