Tax-loss harvesting is the deliberate selling of securities that have declined in value to realize capital losses, which are then used to offset capital gains and potentially reduce ordinary income.
How it works: 1. Identify positions with unrealized losses. 2. Sell those positions to realize the loss. 3. Apply losses to offset capital gains: - Short-term losses offset short-term gains first, then long-term gains. - Long-term losses offset long-term gains first, then short-term gains. 4. If losses exceed gains, deduct up to $3,000 of excess losses against ordinary income per year. 5. Carry forward unused losses to future tax years (indefinitely).
Tax-loss harvesting benefit example: - Portfolio has $50,000 of realized long-term capital gains taxed at 15% = $7,500 tax. - Harvest $50,000 of unrealized losses. - Net capital gain = $0. Tax savings = $7,500. - Reinvest in similar (not substantially identical) securities to maintain exposure.
Wash sale rule: Must not repurchase substantially identical securities within 30 days before or after the sale. Workaround: buy a similar ETF or fund in the interim.
Year-round vs. year-end: Sophisticated advisers harvest losses throughout the year when opportunities arise, not just at year-end.
Long-term cost: Harvesting losses reduces cost basis of replacement securities → higher future gains when eventually sold. Tax-loss harvesting is a deferral strategy, not a permanent elimination.
> Exam tip: Tax-loss harvesting can offset capital gains AND up to $3,000 of ordinary income. The wash sale rule is the primary constraint. Losses carry forward indefinitely. Know that this is a deferral benefit, tested on CFP® and Series 65.