Tax Loss Harvesting: Rules & Examples

Instructor: Ian Lord

Ian is a real estate investor, MBA, former health professions educator, and Air Force veteran.

Tax-loss harvesting is an excellent method for reducing tax obligations, but this lesson explains how investors must also be aware of IRS rules and limits when considering this strategy.

Tax-Loss Harvesting

The end of the year is approaching, and Don is looking over his finances for any final steps he can take to save on his taxes. He's made a few contributions to charity and set money aside into a tax-sheltered retirement account. Let's look into how Don can go about using a strategy known as tax-loss harvesting to reduce his tax bill.

Definition Rules

Tax-loss harvesting is an investment strategy where an investor sells an investment that has gone down in value and buys into another investment. By selling the investment at a loss, Don may be able to deduct that loss from his taxable income. Because the money is still invested, just in a different investment, his overall financial position in the market hasn't changed. This is a making-lemons-out-of-lemonade kind of situation; Don can take a loss on paper which will at least have the benefit of reducing his tax bill.

Let's look at an example. Don purchased $1,000 worth of shares in the XYZ Company at $10.00 per share. Today the shares are worth $9.50. Don would like to switch his money into XYZ's industry rival DEF. After selling the $950 worth of XYZ stock, he purchases $950 worth of DEF. He has the same amount of money invested in the market but is now able to claim the loss of $50 on his tax return. Since Don is in the 25% tax bracket, this $50 deduction allows him to pay $12.50 less on his taxes.

Rules

In order to prevent abuse, the Internal Revenue Service has imposed regulations that specifically disallow buying an investment and then selling it shortly after that at a loss to save on taxes. This is known as the wash-sale rule. Specifically, if Don were to sell an investment at a loss and then purchase a substantially identical investment within 30 days he would not be able to claim a loss. Substantially identical is different from having a high correlation. It would be a problem for Don to sell one S&P 500 fund for another S&P 500 fund, but it would be alright to buy a US total stock market fund since both tend to move up and down in value at the same time.

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