Most investors feel a pang of frustration when they open their brokerage app and see a sea of red. Watching a stock or fund drop in value feels like a personal defeat, but in the world of savvy wealth management, these losses serve a secondary purpose. While you cannot control the market’s daily fluctuations, you can control how those fluctuations impact your tax liability. This process is known as tax loss harvesting.

Tax loss harvesting allows you to sell investments that have declined in value, realize those losses, and use them to offset the taxes you owe on capital gains. If your losses exceed your gains, you can even use the remainder to offset a portion of your ordinary income. It is one of the few ways the Internal Revenue Service (IRS) allows you to “win” even when your portfolio takes a temporary hit.

This tax loss harvesting guide breaks down the mechanics of this strategy, the rules you must follow to stay in the good graces of the IRS, and how to execute this move without disrupting your long-term investment goals.

The Foundation: Understanding Capital Gains Tax

Before you can harvest a loss, you must understand what you are trying to offset: capital gains. When you sell an asset for more than you paid for it (your “cost basis”), the profit is considered a capital gain. The IRS categorizes these gains based on how long you held the asset.

• Short-Term Capital Gains: These apply to assets held for one year or less. They are taxed at your ordinary income tax rate, which can be as high as 37%.
• Long-Term Capital Gains: These apply to assets held for more than one year. These enjoy preferential tax rates of 0%, 15%, or 20%, depending on your total taxable income.

Because short-term gains are taxed at higher rates, they are usually the primary target for an investment tax strategy. By realizing a loss, you effectively lower the “net” gain that the government can tax. For example, if you sell a stock for a $10,000 profit but also sell a different stock for a $4,000 loss, you only owe capital gains tax on the remaining $6,000.

How Tax Loss Harvesting Works Step-by-Step

The mechanics of tax loss harvesting are straightforward, but the execution requires precision. You aren’t just selling a stock because it went down; you are strategically repositioning your portfolio to capture a tax benefit while maintaining your desired market exposure.

1. Identify Underperforming Assets: Review your taxable brokerage accounts for securities currently trading below their purchase price. These are “unrealized losses.”
2. Sell the Security: By selling the asset, you turn that “paper loss” into a “realized loss.” Only realized losses can be used for tax purposes.
3. Calculate the Offset: Apply your realized losses against any capital gains you realized during the same tax year.
4. Reinvest the Proceeds: To keep your portfolio on track, you take the cash from the sale and immediately buy a different security that serves a similar purpose in your portfolio. This ensures you don’t miss out on a potential market recovery.

It is important to note that tax loss harvesting only applies to taxable brokerage accounts. You cannot use this strategy in tax-advantaged accounts like a 401(k), 403(b), or Individual Retirement Account (IRA), because the investments inside those accounts are already tax-deferred or tax-free.

“In this world nothing can be said to be certain, except death and taxes.” — Benjamin Franklin, Statesman and Inventor

The Netting Process: How the IRS Calculates Your Bill

The IRS follows a specific order of operations when you report gains and losses. This is known as “netting.” You cannot simply pick and choose which loss offsets which gain; you must follow the sequence. First, you net short-term losses against short-term gains. Next, you net long-term losses against long-term gains. If you still have a net loss in one category, you can then apply it to the other.

Consider this scenario: You have $5,000 in short-term gains and $2,000 in short-term losses. You also have $10,000 in long-term gains and $12,000 in long-term losses. First, you reduce your short-term gains to $3,000. Then, you realize you have a net long-term loss of $2,000. You can apply that $2,000 long-term loss against your remaining $3,000 short-term gain, leaving you with only $1,000 in taxable short-term gains.

The $3,000 Rule: Offsetting Ordinary Income

One of the most powerful features of tax loss harvesting is what happens when your total losses exceed your total gains for the year. If you have “excess” losses, the IRS allows you to use up to $3,000 of those losses to offset your ordinary income—the money you earn from your job.

If you are in the 24% tax bracket, using a $3,000 loss to offset your income saves you $720 in federal taxes. What if you have $10,000 in losses but no gains? You use $3,000 this year and “carry forward” the remaining $7,000 to future tax years. There is no limit on how many years you can carry forward these losses; they stay on your books until they are fully used up. You can find more details on these limits on the Internal Revenue Service (IRS) website under Publication 550.

The Comparison: Harvesting vs. Holding

To see the tangible value of this strategy, let’s look at how harvesting affects an investor’s bottom line over a single tax year. This table assumes the investor is in the 15% long-term capital gains bracket and the 24% ordinary income bracket.

In the final scenario, the investor saves $1,500 by eliminating the tax on the $10,000 gain and saves an additional $720 by reducing their taxable ordinary income by $3,000. That is $2,220 that remains in the investor’s pocket rather than going to the treasury.

The Wash-Sale Rule: The Trap to Avoid

The IRS is aware that investors might try to sell a stock just to claim the tax loss and then immediately buy it back. To prevent this, they created the “Wash-Sale Rule.” If you sell a security at a loss and buy the same or a “substantially identical” security within 30 days before or after the sale, the loss is disallowed for tax purposes.

This 61-day window (30 days before, the day of the sale, and 30 days after) is a critical component of any investment tax strategy. If you trigger a wash sale, you don’t lose the loss forever, but you cannot claim it in the current tax year. Instead, the loss is added to the cost basis of the new security you purchased, which only helps you when you eventually sell that new security.

What qualifies as “substantially identical”? The IRS has not provided an exhaustive list, but generally, selling the Apple Inc. (AAPL) stock and buying more Apple Inc. stock the next day is a clear violation. However, selling an S&P 500 Index Fund from one provider and buying an S&P 500 Index Fund from a different provider might also be considered “substantially identical” because they track the same underlying index. Many investors circumvent this by selling a fund that tracks one index (like the S&P 500) and buying a fund that tracks a different but highly correlated index (like the Total Stock Market Index).

Strategic Timing: Beyond the December Rush

Many investors wait until the last week of December to look for tax loss harvesting opportunities. While this is better than doing nothing, “year-round” harvesting is often more effective. Markets don’t only dip in December. If a specific sector crashes in May, that is the time to harvest the loss.

Waiting until December can be risky for two reasons. First, the market might have recovered by then, erasing the “paper loss” you intended to harvest. Second, if many investors sell the same assets at year-end, it can create downward pressure on prices, though this is less of a concern for highly liquid stocks and ETFs. By monitoring your portfolio quarterly, you can capture volatility whenever it occurs.

Professional vs. Self-Guided Harvesting

Tax loss harvesting can be a manual, tedious process, or it can be entirely automated. Deciding which route to take depends on your comfort level with tax forms and the complexity of your portfolio.

Scenario 1: The DIY Investor
If you hold only a few individual stocks or ETFs and trade infrequently, you can likely manage harvesting yourself. You will need to track your cost basis carefully and ensure you do not violate the wash-sale rule across different accounts (including your spouse’s accounts). You should consult the Securities and Exchange Commission (SEC) resources to understand the risks of frequent trading.

Scenario 2: The Robo-Advisor User
Platforms like Betterment, Wealthfront, or Fidelity Go offer automated tax loss harvesting. These services use algorithms to scan your portfolio daily for harvesting opportunities. When a loss reaches a certain threshold, the software automatically sells the position and replaces it with a correlated but not “substantially identical” asset. This is often the most efficient route for busy investors.

Scenario 3: High Net Worth Individuals
If you have a complex portfolio with private equity, real estate, and high-volume stock trading, a Certified Financial Planner (CFP) or a CPA is essential. They can coordinate losses across multiple entities and ensure your harvesting strategy doesn’t interfere with other goals, like estate planning or charitable giving.

Common Mistakes to Avoid

While tax loss harvesting is a powerful tool, it is easy to make mistakes that negate the benefits or create a headache during tax season.

• Forgetting the “Whole Picture”: The IRS looks at all your accounts collectively. If you sell a stock at a loss in your individual brokerage account but your spouse buys that same stock in their IRA within the 30-day window, you have triggered a wash sale.
• Ignoring Transaction Costs: If you are paying high commissions to sell and buy securities, the cost of the trades might outweigh the tax savings. In the era of zero-commission trading, this is less common, but still relevant for certain mutual funds or specialized assets.
• Letting the “Tax Tail Wag the Investment Dog”: Never sell a high-quality investment that you believe in solely for a tax break if you don’t have a suitable replacement. Your primary goal is to grow your wealth; tax savings are secondary.
• Misunderstanding Deferral vs. Elimination: Tax loss harvesting is often a tax deferral strategy. When you sell an asset and buy a new one, your new cost basis is lower. This means when you eventually sell the new asset years down the line, your capital gain will be larger. However, the goal is to pay those taxes later (ideally at a lower future rate) and keep your money invested and compounding in the meantime.

Frequently Asked Questions

Can I harvest losses in my 401(k)?
No. Tax loss harvesting only works in taxable brokerage accounts. Since 401(k)s and IRAs are already tax-advantaged, the IRS does not allow you to claim capital losses within them.

What is the maximum amount I can harvest?
There is no limit on how much you can harvest to offset capital gains. If you have $1 million in gains and $1 million in losses, you can offset the entire amount. However, you are limited to using $3,000 of excess losses to offset ordinary income per year.

Does tax loss harvesting work for cryptocurrency?
Currently, the IRS treats cryptocurrency as property. While wash-sale rules have historically been less clear for crypto, recent and pending legislation aims to apply the same wash-sale restrictions to digital assets that apply to stocks and bonds. It is safest to assume the 30-day rule applies.

Do I have to reinvest the money immediately?
No, you can keep the cash. However, most investors reinvest the money to ensure their portfolio remains balanced and they don’t miss out on market gains while sitting on the sidelines.

Next Steps for Your Portfolio

To begin using this strategy, start by reviewing your “unrealized gains and losses” screen in your brokerage account. Look for positions that are currently “underwater.” If you decide to sell, make sure you have a replacement asset in mind to maintain your market exposure, and set a calendar reminder for 31 days out to ensure you don’t accidentally trigger a wash sale by buying the original asset back too soon.

Tax loss harvesting is a hallmark of sophisticated investing. It transforms market volatility from a source of stress into a structural advantage for your wealth-building journey. By staying disciplined and following the IRS rules, you can ensure that even your “losing” investments contribute to your long-term financial success.

This article provides general financial education and information only. Everyone’s financial situation is unique—what works for others may not work for you. For personalized advice, consider consulting a qualified financial professional such as a CFP or CPA.

Last updated: February 2026. Financial regulations and rates change frequently—verify current details with official sources.