What is Tax-Loss Harvesting?

Tax-loss harvesting is a strategic investment technique used to minimize capital gains taxes. The concept is simple: you sell investments (like stocks, mutual funds, or cryptocurrency) that have declined in value. The "realized loss" from that sale is then used to offset the "realized gains" from investments you sold at a profit.

If your losses exceed your gains for the year, you can even use those losses to offset your ordinary income, saving you money on your tax bill.

How Capital Losses Offset Capital Gains

When you file your taxes, the IRS requires you to net your capital gains and losses against each other.

  • Short-term vs. Long-term: First, short-term losses offset short-term gains, and long-term losses offset long-term gains.
  • Netting it out: If you have an overall net capital loss, you can use up to $3,000 of that loss to offset your ordinary income (like your salary or wages).
  • Carryover: If your net capital loss exceeds $3,000, you don't lose it! You can carry the excess loss forward indefinitely to future tax years.

The Wash-Sale Rule: The Ultimate Trap

Tax-loss harvesting sounds amazing, but there is a major catch: The Wash-Sale Rule.

The IRS prohibits you from claiming a tax loss if you sell a security at a loss and then buy a "substantially identical" security within 30 days before or after the sale. If you do this, the IRS will disallow the loss, and the loss amount will be added to the cost basis of the new shares.

Example: You sell 100 shares of Apple at a $500 loss. Two weeks later, you buy 100 shares of Apple again. You cannot claim the $500 loss on your taxes this year.

Workarounds: To stay invested in the market while avoiding the wash-sale rule, investors often swap their losing stock for a highly correlated exchange-traded fund (ETF). For example, if you sell a specific S&P 500 ETF at a loss, you can immediately buy a different S&P 500 ETF from a different provider. The IRS generally considers them different securities.

Does the Wash-Sale Rule Apply to Cryptocurrency?

As of 2024, the wash-sale rule applies to stocks and securities, but not to cryptocurrency. Because the IRS classifies cryptocurrency as "property" rather than "securities," the wash-sale rule currently does not apply.

This means a crypto investor can theoretically sell Bitcoin at a loss to harvest the tax deduction, and immediately buy the Bitcoin back a minute later. However, Congress has repeatedly proposed closing this loophole, so crypto investors should proceed with caution and consult a tax professional.

When Should You Harvest Losses?

Many investors wait until December to look for tax-loss harvesting opportunities. However, the best approach is to harvest losses year-round during market dips. By utilizing tax-loss harvesting strategically, you can significantly improve your portfolio's after-tax returns over time.