Tax-loss harvesting is the practice of selling investments that have dropped in value to claim a capital loss, which can offset capital gains and reduce a tax bill.

How it works

Suppose someone sold a stock at a $5,000 gain earlier in the year. Without further action, tax is owed on that gain. If another investment is sitting at a $5,000 loss, that investment can be sold before year-end. The loss offsets the gain. Net taxable amount on those two trades: zero.

When net losses exceed net gains, the IRS allows up to $3,000 to be deducted against ordinary income each year, with the remainder carried forward to future years.

The wash-sale trap

If the same security (or a 'substantially identical' one) is purchased within 30 days BEFORE or 30 days AFTER the loss sale, the IRS disallows the loss under the wash-sale rule. (The full window is 61 days, 30 days on each side of the sale, plus the sale day itself.) The standard workarounds are waiting 31 days after the loss sale (and not having bought in the prior 30) or buying something similar but not identical, for example, swapping one S&P 500 ETF for a different broad-market ETF.

Sources

• IRS Topic No. 409, Capital Gains and Losses: https://www.irs.gov/taxtopics/tc409
• IRS Publication 550, Investment Income and Expenses: https://www.irs.gov/publications/p550