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Tax-loss harvesting

Tax-loss harvesting is a strategic method to reduce your tax bill by selling investments that have declined in value from their purchase price within taxable accounts such as individual or joint brokerage accounts. This technique allows you to offset realized gains—profits from selling investments at a higher price than their purchase price—elsewhere in your portfolio, potentially reducing your taxable income.

Tax-loss harvesting turns on the distinction between realized and unrealized positions. An unrealized gain or loss is relevant for investments you still hold. It represents the difference between the current market value of an asset and its original purchase price, or cost basis. This gain or loss only becomes realized when you sell the investment. At that point, the difference between the sale price and the cost basis becomes a factor for tax purposes.

To implement tax-loss harvesting effectively, keep these key points in mind:

Timing: The end of the fiscal year is a common time to assess your portfolio for tax-loss harvesting opportunities, but monitoring your investments regularly allows for more strategic decisions throughout the year.
Wash Sale Rule: The IRS prohibits claiming a tax deduction for a security sold in a wash sale. A wash sale occurs if you buy a “substantially identical” security within 30 days before or after selling a security at a loss. To avoid this, consider replacing the sold security with one that serves a similar role in your portfolio but is not considered substantially identical. You can replace it with an ETF or mutual fund that provides exposure to the same asset class, and often a similar segment of that asset class.
Offset Gains with Losses: First, use your realized losses to offset any realized gains. If your losses exceed your gains, you can use up to $3,000 ($1,500 if married filing separately) of excess losses per year to offset other income, such as wages. Any remaining losses can be carried forward to future tax years indefinitely.
Long-Term vs. Short-Term: Losses do not automatically find their highest-value use. IRC §1222 nets short-term against short-term and long-term against long-term first, and only the two surviving figures are crossed. That makes a short-term loss the more valuable harvest: it shelters short-term gains taxed at ordinary rates — up to 40.8% with the NIIT — while a long-term loss shelters gains taxed at 23.8% at the top. Match the character of the loss to the character of the gain you are trying to kill.

Sell the shares you meant to sell. A harvest only works if the broker disposes of the lots you intended. The default cost-basis method on most accounts is FIFO, which sells the oldest shares first — in a long-held position, the lowest-basis ones — and can turn an intended loss into a realized gain. Set the account to specific identification (or its automated cousin, highest-in-first-out) and name the lots on every harvest trade. Treas. Reg. §1.1012-1(c) sets the deadline: the identification must reach the broker no later than settlement — T+1 for equities — and the broker must confirm it in writing, though a standing instruction on the account also counts. What does not count is fixing it in April. You cannot re-designate lots on the return after the fact, and the Form 1099-B has already gone to the IRS saying otherwise.

Harvesting defers the tax; it does not erase it. The replacement position carries a lower basis than the one you sold, so the loss you deduct this year comes back as a larger gain whenever you finally sell the replacement. What you genuinely harvested is three things: the use of the deferred tax money in the meantime, a rate spread if the loss offsets ordinary or short-term income now while the deferred gain is long-term later, and true permanence only in the cases where the deferred gain is never taxed at all — the position is held until death and the basis steps up (section “Capital Gains Resets With Inheritance”), or the appreciated replacement is donated to charity (section “Donate Appreciated Securities”). That is a real benefit. It is not the “savings” number in the brochure. It also means harvesting is close to pointless in a year your gains already sit in the 0% long-term bracket (section “Harvesting the 0% LTCG Bracket”) — you would be spending a deduction worth nothing today to shrink a basis that costs you later. Harvest because the tax arithmetic works, not simply because the position is down.

Direct indexing: TLH at scale. A single broad-market ETF offers no harvest opportunities once the fund as a whole is up: the IRS sees one position, and the position is green. Direct indexing replaces that single fund with the underlying 300, 500, or 1,000 component stocks held in your own account, each with its own basis. Even in a year the index is up 20%, a meaningful subset of names is down — and each of those positions can be harvested individually without selling the winners, with the proceeds rotated into a non-substantially-identical replacement (a different sector ETF, or a different name in the same sector) for the 31-day window. At larger portfolio sizes the harvested losses run 2–5% of portfolio value per year in the early years, then decay as the embedded gain on the original lots dominates. Size the benefit before you pay for it: on a portfolio of value $V$ , a harvest yield $h$ , a capital-gains rate $τ_{cg}$ , and an all-in management fee $f$ , the first-order annual tax alpha is

α = V (h τ_{cg} - f)

For a $5M portfolio at $h = 3 %$ , $τ_{cg} = 23.8 %$ , and $f = 0.30 %$ , that is $$ 5 M \times (0.00714 - 0.0030) = $ 20, 700$ a year — positive, but a good deal thinner than the marketing implies, and it turns negative once $h$ decays below $f ∕ τ_{cg} \approx 1.26 %$ . That crossover, not the headline harvest rate, is the number to track. The losses offset $3,000 of ordinary income annually and an unlimited amount of realized capital gains — making direct indexing the natural pair for an investor with concentrated equity-comp gains, a recurring private-company exit, or a long-dated estate plan that anticipates basis step-up at death anyway. The cost of the service has compressed: most large brokerages now offer direct indexing as a managed-account product at 15–40 bps on top of zero-commission execution. The fee plus tracking error against the underlying index has to be weighed against the realized tax alpha; for a high-bracket investor with substantial taxable gains, the trade is almost always positive in the first decade of the account and turns marginal once the harvest yield decays.

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