Tax loss harvesting is a tax strategy in which stocks are sold at a loss to offset capital gains, thereby reducing tax liability. This approach allows investors to turn market volatility into opportunity by capturing immediate, valuable tax benefits.

Key takeaways:

• The value of a tax loss to offset realized gains is that it can help reduce tax drag and keeps more money invested and compounding in the market. 
• The wash sale rule is an important consideration for investors engaging in tax loss harvesting, as violating it will disallow the realized loss. 
• Proceeds from loss harvesting are reinvested in order to maintain market exposure; this has the effect of lowering the portfolio’s cost basis over time.
• Long-term capital gains rates are preferential (or lower) than short-term capital gains rates, which makes gain deferral a valuable tax benefit.

What is tax loss harvesting?

Tax loss harvesting is a strategy for saving on taxes. It involves intentionally selling a stock at a loss for tax purposes. These realized losses can be used to offset current or future realized capital gains, which reduces or may even eliminate the investor’s tax liability.

Intentionally selling a stock at a loss doesn’t sit well with many. If the investor’s goal is to make money, why is he or she capitulating and selling? Often, an active manager will wait for the stock to bounce back or even “double down” by buying more shares at a cheaper price to amplify returns if there is a rebound. Of course, this risks even heavier losses if that doesn’t materialize.

The core benefit of tax loss harvesting is in prioritizing the known, quantifiable benefit of tax savings over the unknown future performance of the stock. This is much easier for an index-based strategy where the goal is to simply match the index’s performance. That’s because the manager doesn’t have an “alpha thesis,” or conviction, about the company’s future performance. If a stock has a large-enough unrealized loss, it’s a candidate to sell for tax purposes.

Tax loss harvesting is a crucial part of direct indexing strategies, where individual stocks are purchased to create a portfolio that mirrors the performance of a preselected index.

IRS regulations and the wash sale rule

The IRS allows taxpayers to claim a deduction for realized losses. These losses can offset realized capital gains for that tax year, or if no gains exist, reduce ordinary income by up to $3,000 for those who are married and filing jointly. Excess losses above $3,000 can be carried forward to the next tax year, making them valuable future write-offs.

For a loss to be legitimate – meaning it can be used to offset gains in the current tax year – it can’t violate the “wash sale rule.”  A wash sale takes place when an investor sells a security at a loss and then buys a substantially identical security within 30 days before or after the sale. Very simply, there’s a cooling-off period that prevents investors from having their cake and eating it too – they can’t get both favorable tax treatment by claiming a loss and the benefit of an immediate recovery in the stock’s price.

A wash sale violation results in a disallowed loss – and the taxpayer can’t immediately claim a deduction on the loss from the sale. The amount of the disallowed loss is added to the basis of the new shares – and the holding period for the replacement stock includes the holding period of the stock sold.

For example, a wash sale violation with a $2 disallowed loss on a $10 stock will increase its cost basis to $12. If the price remains stable and is sold for $10 after the wash sale period, the $2 loss will be recognized and claimable.

One risk of tax loss harvesting is that the sold position quickly bounces back. To ensure the deductibility of the loss, a replacement stock or exchange-traded fund (ETF) that’s similar (but different) is typically purchased instead to mitigate the risk of a quick rebound.

If Pepsi stock is sold for a loss, for example, Coca-Cola might be considered a suitable replacement security to maintain market exposure. If Pepsi rebounds, Coca-Cola might act similarly but not be considered “substantially identical” for the wash sale rule. Sector-based ETFs are also commonly used – in this case, a Consumer Staples ETF might provide acceptable beta exposure and correlation to Pepsi. Sitting in cash until the wash sale period is over is an option but carries the opportunity cost of being out of the market.

How tax loss harvesting works

The benefit of tax loss harvesting is that realized capital losses are netted against realized gains to reduce or offset realized capital gains. The value of these losses reduces taxable income dollar for dollar and results in less taxes being owed.

To illustrate the concept, imagine investors who are in the 37% marginal tax bracket. It’s December 30, and they find themselves with $10,000 in realized short-term capital gains. At the 37% tax rate, they have a provisional tax liability of $3,700. However, if they can identify shares selling below their cost basis and generate $10,000 in losses by year end, they can completely wipe out that liability. Their tax return would show a net capital gain of $0. Note that the investors didn’t root for any stocks to go down or lose money, they just looked through their portfolios for tax lots whose market value is less than their cost basis.

The $3,700 saved stays invested in the market, and the gain is deferred into the future. This is the equivalent of an interest-free loan from the US Treasury and allows more money to compound in the market without tax drag.

Notably, if the $10,000 loss was instead taken in January of the next year, the investors would have to pay the $3,700 in taxes, creating a tax drag on their portfolios. The January loss might be useful if other gains are recognized in that calendar year; otherwise, only $3,000 can be written off against income, and the $700 carries over to the next tax year.

Direct indexing strategies seek to match the performance of an index on a pretax basis and outperform on an after-tax basis. Much of that after-tax outperformance comes from deferring the payment of capital gains by proactively harvesting losses throughout the calendar year, powered by rules-based algorithms.

Is the strategy to lose money?

No, the strategy is to minimize taxable gains by maximizing capital losses. Because losses can offset gains, this reduces taxes owed today and delays the payment to some date in the future.

Investors know that equities are a risky asset that regularly experience volatile price swings. This naturally occurring volatility presents an opportunity to capture valuable tax deductions.   

In you’ve ever planted a garden, you know that along with blossoming flowers come weeds that need to be handled. The weeding of the garden and harvesting of losses are similar. We’re not hoping for weeds or losses, but we know they are the cost of admission and deal with them accordingly. The loss harvesting process is simply reviewing the portfolio looking for available tax lots to sell that make it worthwhile from a tax perspective.

In 2024, even as the S&P 500^® returned 25%, 35% of the individual stocks lost money, creating 175 potential tax loss harvesting opportunities while the overall portfolio gained value. Regularly combing a portfolio for losses is important, as volatility can spike at any time.

What’s the catch?

Upon liquidation, a portfolio that has been consistently tax loss harvested will have to realize capital gains. That’s because every time a loss is harvested, the cost basis of the portfolio is reduced. The good news is those gains are usually long term, and the long-term capital gains tax rate is always less than the short-term rate, potentially saving up to 20%.

2025 tax rates across taxable income levels (married filing jointly)

Note: Does not include the 3.8% net investment income tax (NIIT), which applies to individuals, estates, and trusts that have net investment income above applicable threshold amounts. Capital gains rate is 0% up to $96,700.
Sources: IRS, Natixis Investment Managers Solutions

Continuing with our cola wars example, if some investors buy Pepsi stock on January 1 for $10,000 and sell it on February 1 of the same year for $7,000, they have booked a $3,000 short-term capital loss. They immediately use the $7,000 in proceeds to buy Coca-Cola stock on February 1. On March 1 of the following year, Coca-Cola is worth $11,000 and they liquidate their position. They just realized a long-term capital gain of $4,000 in Coca-Cola. We’ll call this Scenario 1.

In Scenario 2, let’s assume Pepsi and Coca-Cola’s performance over the period was identical. So that if the investors simply held onto Pepsi from January 1 to March 1 of the follow year, they’d have $11,000 and would realize a $1,000 long-term capital gain.

This is where most of the confusion arises – what’s the difference between Scenario 1 and 2 if the investors end up with $11,000 in both cases?

In Scenario 1, the long-term capital gains tax on $4,000 is $600 vs. $150 in Scenario 2. That’s the “gotcha” component – tax loss harvesting creates larger future capital gains (assuming a rising market) when the proceeds are reinvested because the cost basis of the new shares is lower than the purchase price of the sold shares.

But note that in Scenario 1, the short-term loss was available to offset up to $3,000 in ordinary income (or other capital gains). If they had $450,000 in taxable income from their employment, they would write off $3,000 and be taxed on $447,000, saving $960 in taxes. While Scenario 2 seems like a better deal with only a $150 tax burden, when you consider the write-off from the $3,000 loss harvesting trade, Scenario 1’s fact pattern is superior since the net tax savings was $360 ($960 in taxed saved, reduced by a $600 tax bill).

Tax harvesting scenarios

Tax-efficient investors try to defer the realization of gains as long as possible by holding onto the stock. In low-income years, gains can be strategically realized to fill up the 0% long-term capital gains bracket. And donating appreciated long-term shares to a charity can generate a charitable deduction for the taxpayer and avoid paying capital gains tax on the appreciation. If gains are deferred long enough, the account owner’s heirs will get a step-up in cost basis to market value upon the account owner’s death, eliminating the built-in tax liability.

How do I explain tax loss harvesting to my clients?

The term “loss” can quickly cause any investor to get confused, lose interest, and misunderstand the strategy. It’s important to explain that we’re using the tax code to our advantage when we tax loss harvest a portfolio. The portfolio’s value is the same whether a loss is booked or not. But the value of a tax loss to offset current or future gains helps keep more money invested in the market and compounding wealth.

To avoid confusion, we often steer away from the word “loss” and instead use terms such as “tax write-off,” “tax deduction,” “tax savings,” or “tax benefit” to illustrate the usefulness and value of a tax loss harvesting strategy. These phrases resonate better and carry a more positive connotation.

For those with experience investing in real estate, they know their cash flow has no relation to what they pay for taxes. The tax construct of depreciation is similar to loss harvesting: it’s a write-off for tax purposes but doesn’t impact the asset’s economic value.

For more on this topic, see: Tax loss harvesting: When realized losses may be less useful

Direct indexing investing strategies

Direct indexing can play a valuable role in a tax-efficient investment strategy, especially for high-net-worth investors. Let us help you create portfolios that put taxes first.