How to Tax Loss Harvest

The following is not financial or tax advice. Please consult a CPA or investment professional before making tax or investment decisions.

Taxes are one of the few things you have some control over as an investor. When you have a taxable brokerage account you will generate gains and potentially losses from the sale of securities. One of the best ways you can improve your after-tax investment performance is via tax loss harvesting.

Understanding Capital Gains

American taxes are broadly divided into ordinary income and capital gains. Ordinary income is generated from working and interest income. A capital gain is the difference between your sale price and your purchase price (basis) or if short selling your sale price and purchase. Qualified dividends are also given capital gains treatment.  If a stock is sold in less than 1 year it generates short-term capital gains that are equal to your ordinary federal income tax rate. Stock held for more than 1 year create long-term capital gains that have more favorable federal tax rates of 0-20% depending on your income.

Tax loss harvesting generates a tax loss you can use to offset other capital gains in your account or if your capital losses exceed your capital gains, to offset up to $3,000 (married) or $1,500 (single) in ordinary income. The loss from a given year that exceeds the $3,000 can also be “carried over” indefinitely meaning if you have a $10,000 loss in 2025 you would be eligible to offset $10,000 in capital gains in 2026 and thereafter until you have offset $10,000 in gains.

Capital gain taxation varies significantly by state, a full list of state capital gains rates is available here. Eight states (Alaska, Florida, Nevada, New Hampshire, South Dakota, Tennessee, Texas, and Wyoming) do not tax capital gains. Five states (California, Minnesota, New Jersey, New York, and Oregon) have capital gains taxes that are near 10% or higher. Many states such as Alabama, Maryland, and California tax capital gains at the same rate as ordinary income. California has the highest capital gains rate at 13.3%, but it only kicks in on incomes above $721,315 if filing as single or $1,442,629 for married couples.

The Purpose of Tax Loss Harvesting

The point of tax loss harvesting is to create a tax loss by selling a security on which you have an unrealized loss while maintaining the same broad allocation in your portfolio. This allows you to get the tax benefit now of the unrealized loss you currently have without dramatically changing your portfolio’s allocation. Cash now is always worth more than cash in the future so realizing a tax loss now increases your after tax returns in the long run. Furthermore a security may be in a loss position now, but may become a gain by the time your are ready to sell.

Tax loss harvesting with individual stocks

In addition to preventing swaps into substantially identical securities, the IRS also prohibits you from selling and then immediately buying back a security via what is called the Wash Sale Rule. Under this rule you are prohibited from buying a substantially identical security within 30 days before or after your sale. The 31 days is basically a way of the IRS forcing you to risk losing the return of the security over this period. If you do not think that there will be major movements in the stock and you have a significant tax loss that is worth harvesting, it may be worth taking the risk that the security rises a lot in the interim. On average markets rise so its not inconceivable that you tax loss harvest and end up having to buy back your security at a higher price.  

Tax loss harvesting with diversified Exchange Traded Funds (ETFs) or mutual funds 

The IRS is not a huge fan of tax loss harvesting. They try to prevent tax payers from getting a free lunch by selling a security to generate a tax loss than buying a substantially identical security. A substantially identical security  isn’t well defined, but usually means the ETF or mutual fund has the same underlying positions or tracks the same index. In practice this means you cannot buy SPY which is an S&P 500 ETF and then immediately swap into IVV which is another S&P 500 ETF.

However as is often the case in life, there is a work around. If you find a security that is highly correlated (meaning it moves in tandem with the other security and has similar but not identical underlying companies) with but not substantially identical to another security you can generate a tax loss without drawing the IRS’ ire. Although there are no hard and fast rules, a few ways to find a correlated but not substantially identical security are by looking for an active versus passive fund with the same underlying benchmark, a value/growth variant of a similar index, or finding a security in the same asset class, but which tracks a different index. ETFDb has a great list of alternative ETFs for each security within a given asset class. Just search for the ETF you are looking for and then scroll to the bottom of the page for a list of alternatives.

You start by identifying a security that gives you similar exposures to the asset class of the ETF you are selling. For example, if you are selling EFA, an International Developed ETF that follows the MSCI EAFE Index and swapping with the Vanguard FTSE Developed Markets ETF, this should be acceptable to the IRS due to both ETFs having different underlying indexes  (FTSE Global All Cap ex US index vs MSCI EAFE). They are similar indexes with a high correlation to one another, but ultimately have different exposures as some countries are excluded from EFA that are included in VEA.

In the example below you retain exposure to large cap stocks that are present in the S&P 500, but via DIA which tracks the Dow Jones Industrial average comprised of large cap stocks. The Dow Jones is not a perfect representation of the S&P 500 as it only has 30 stocks, has less technology, and has an archaic price-based index formula, but it will provide returns that have historically been 90%+ correlated with the S&P 500.

Example:

Step 1: You own 100 shares of SPY

Step 2: SPY falls in value by $25 creating an unrealized loss

Step 3: Sell your 100 shares of SPY for $47,500 generating a $2,500 tax loss

Step 4: “Swap” SPY for DIA by purchasing $47,500 shares of SPY

Step 5: Wait 30 days after your sale

Step 6: On the 31^st day or after your sale if DIA has fallen sell it and buy back into SPY. If DIA risen in value keep it in your portfolio.

Caveats and risks

There are two major risks with tax loss harvesting: the IRS disallows the swap and your swaps result in a portfolio with different exposures than your originally intended. There is always a risk that the IRS audits you and deems the securities you swapped into substantially identical and forces you to change the basis on your stock thereby producing a tax liability. Given the current state of the IRS where audits are falling, this risk is lower than it has been in the past and as long as your swap isn’t glaringly similar you should be okay.

The second risk is a little more theoretical. Your initial portfolio allocation or the percentage you put into each kind of asset class will inherently start to drift in the direction of particular assets that perform better. For example, as the S&P 500 outperformed virtually every asset class in the last decade, a much higher percentage of your portfolio than you initially intended is likely to be US large capitalization equities.

Usually you deal with this “style drift” by rebalancing. When you tax loss harvest your replacement security is always slightly different than your original allocation. Do enough tax loss harvesting and eventually your portfolio will significantly drift from your original intent, however if you are doing it right, it should still be highly correlated with your original investments. Rebalancing back to your original portfolio becomes more difficult as you will likely have embedded taxable gains that will reverse some of the tax losses you previously realized.

Tax Loss Harvesting Investment Vehicles

One of the current popular investment trends is investment vehicles that provide exposure to an index with built in tax loss harvesting. In some cases they even claim to generate ordinary income losses. These strategies have not really stood the test of the time as they are relatively new, have relatively high fees, and although they have mechanisms to prevent style drift, I remain unconvinced they would hold up in a market dislocation.

Frec is one product that give you direct indexing and “supercharged tax savings” in addition to really cheap margin rates.  The minimum investment on Frec is only $20k. AQR has several “tax aware” strategies that seek to generate short-term losses. AQR’s strategies tend to have a minimum net worth in the seven figures. There are also a few long-short hedge funds that offer similar strategies with higher fees that are usually limited to accredit investors.