Tax-loss harvesting and the wash-sale rule.

Tax-loss harvesting

Tax-loss harvesting essentially means selling securities that have lost value in order to offset capital gains on your tax return. The losses and the gains must occur in a taxable account—for example, IRAs and 401(k)s aren’t eligible for tax-loss harvesting.

If your capital losses exceed your capital gains in a given year, you can use the losses to reduce your ordinary taxable income by up to $3,000 (up to $1,500 each for married persons filing separately). And any losses left over can be used in future years, without expiration during your lifetime—up to the same yearly limit.

For example, if you sold shares of a stock for $20,000 more than you originally purchased them less than a year ago, this would be a short-term capital gain, taxed as ordinary income. If you also sold shares of another stock for $25,000 less than you paid, your loss would offset the full $20,000 gain. You’d owe no taxes on the gain and would have $5,000 left over to offset ordinary income (up to $3,000 in the current year, with $2,000 left for use in the following year).

Using a $25,000 tax loss to get a tax break

In this example, the investor realized $20,000 in capital gains and $25,000 in capital losses. The losses offset gains first; the excess is then applied to ordinary income and finally to future gains or income.

$20,000 offsets capital gains | $3,000 offsets ordinary income | $2,000 offsets future gains or income $20,000 offsets capital gains | $3,000 offsets ordinary income | $2,000 offsets future gains or income
$20,000 offsets capital gains | $3,000 offsets ordinary income | $2,000 offsets future gains or income $20,000 offsets capital gains | $3,000 offsets ordinary income | $2,000 offsets future gains or income
What it saves you in taxes:
  • $7,000
    (35% of $20,000)
  • +
  • $1,050
    (35% of $3,000)
= $8,050 Potential Tax Saved

This strategy can offer substantial tax savings in the near term, as you can see in the chart above. But in practice, it’s important to consider how long you’ve held the securities. A long-term loss (from the sale of a security held one year or more) would first be applied to a long-term gain. A short-term loss (from the sale of a security held for less than one year) would be applied to a short-term gain. If there are excess losses in one category, these can then be applied to gains of either type.

Also, it’s important to keep in mind that, assuming a loss sale and subsequent purchase at lower market levels than the original purchase, generally tax-loss harvesting will have the effect of lowering the overall portfolio cost basis and thus potentially increasing future gains. Of course, any future gain is offset by the current loss so that you’re no worse off than before, assuming that your replacement security performs as well as the original, transaction costs are immaterial, and future tax rates remain the same (lower future rates would increase the benefit, while higher future rates would decrease it).

So why harvest losses at all? The potential benefit lies with the time value of money and your ability to invest current tax savings for additional future growth (see example below).

Harvesting losses as part of your long-term planning

Harvesting losses regularly and proactively—when you rebalance your portfolio, for instance—can save you money over the long run, effectively boosting your after-tax return.

For example, imagine a $100,000 portfolio of 10 stocks, each holding worth $10,000. The portfolio returns 8% for the year as a result of six stocks gaining 20% on average ($12,000 in gains) and four stocks losing 10% on average ($4,000 in losses).

Assuming you can find better prospects elsewhere—the investment decision should always come first—replacing the four losers makes $4,040 ($40 in hypothetical commissions) of realized losses available to offset realized short-term gains.

Supposing you could use the entire $4,040, a combined federal/state marginal tax bracket of 40% may result in a net savings of $1,576 ($1,616 tax savings, less $40 commissions paid). You might also have a potentially better-positioned portfolio going forward.

Even in a combined marginal bracket of 30%, just taking advantage of the annual $3,000 capital-loss limit against ordinary income means potentially an extra $900 per year in your pocket (minus commissions, if any). Assuming an average annual return of 6%, reinvesting $900 each year would amount to approximately $35,000 after 20 years.

That should more than offset the additional capital gains tax if you end up selling the replacement securities with their lowered cost basis. In fact, if you donate shares to charity or bequeath shares to heirs who receive a step-up in basis, the tax savings from loss harvesting would be permanent.

The wash-sale rule.

If you want to sell a stock to take a tax loss, it’s important to understand the wash-sale rule. Violation of this rule, whether intentional or unintentional, may result in your loss being disallowed.

The wash-sale rule is designed to prevent taxpayers from taking losses on securities if they acquire a substantially identical position within 30 days. Here’s some background on the rule and answers to common questions about it.

Q: I want to sell a stock to take a tax loss, but I plan to buy it again because I want it in my portfolio. What are the tax implications?

A: If you sell a security at a loss and buy the same or “substantially identical” stock or security within 30 calendar days before or after the sale, the loss is typically disallowed for current income tax purposes. This is because of the wash-sale rule.

Q: How do wash sales work?

A: A wash sale will trigger several consequences. First, if you violate the wash-sale rule, you can’t claim your loss. Instead, your loss will be added to the cost basis of the replacement purchase. When you sell the replacement stock, you can recognize the previously disallowed loss. Your holding period for the replacement stock includes the holding period of the stock you sold.

Here’s a quick example of a wash sale.

On 9/30/XX, you buy 500 shares of ABC at $10 per share. One year later, the stock price starts to drop, and you sell all your shares at $9 per share on 10/4/XY. Two days later, on 10/6, ABC bottoms out at $8 and you buy 500 shares again. This series of trades triggers a wash sale.

The holding period of the original shares will be added to the holding period of the replacement shares, effectively leaving you with a long-term position. Additionally, the cost basis on your 10/6 purchase will be adjusted to $4,500, reflecting the cost of acquisition ($4,000) plus the $500 disallowed loss from your 10/4 sale.

Q: If I purchase and sell shares of a stock at a loss in one of my Schwab accounts and then repurchase them in another Schwab account, will I still trigger the wash-sale rule?

A: Yes. Wash-sale rules apply to the investor rather than to a particular account when an investor holds multiple accounts. IRS regulations only require Schwab to track and report wash sales on the same CUSIP number (a unique nine-character identifier for a security) within the same account. Individual taxpayers are responsible for tracking sales in different accounts (their own and their spouse’s) for the purposes of the wash-sale rule.

Q: Does the wash-sale rule apply to options, ETFs, and mutual funds?

A: Yes. Keep in mind that if the security has a CUSIP number, then it’s subject to wash-sale rule reporting. Switching from one ETF to the identical index in another fund or ETF could trigger the wash-sale rule.

Q: What happens if I sell at a loss in a taxable account and then immediately repurchase it in a retirement account, such as an IRA?

A: The IRS has ruled (Rev. Rul. 2008-5) that when an individual sells stock or securities for a loss and causes their IRA or Roth IRA to buy substantially identical stock or securities within 30 days before or after the sale, the loss on the sale is not allowed under Section 1091 and the individual’s basis in the IRA or Roth IRA is not increased by virtue of Section 1091(d).

Q: Can I sell at a loss on December 15 in order to harvest losses for the current tax year and then purchase the shares back in early January?

A: No. Wash-sale rules are not confined to calendar years, so in this situation your loss would be deferred if you reacquired the position within 30 days.

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