A popular strategy used by investors to reduce their federal income tax liability is tax loss harvesting. With this tactic, you may be able to completely offset short-term and/or long-term capital gains to eliminate the need to pay taxes on those profits.
The important thing to remember is that the IRS has strict rules that govern harvesting of tax losses, so you have to be sure to abide by their rules. I've explained these rules in this post to help you take advantage of this strategy with your own investments.
What is Tax Loss Harvesting?
When you buy various equities and securities like stocks, bonds, ETFs and even cryptocurrencies, you'll eventually end up with either a profit or a loss on each trade. When you make money, you're taxed by the US government for those earnings. However, losses can be used to offset your earnings to reduce or even completely eliminate your tax liability from capital gains.
Anything that is taxed by the government as capital gains can potentially be used to harvest tax losses. For example, if you buy a house and sell it at a loss, that can be used to offset other gains.
By carefully keeping track of your profits throughout the year, you can book losses on purpose to help ensure that you don't pay taxes on your gains or at least to reduce your tax liability. You need to make sure you follow the various rules that the IRS has laid out for tax loss harvesting though.
One of the main harvesting rules that you'll need to keep in mind is the deduction limit. There is a $3,000 deduction limit for losses, but this limit only applies after all gains have been offset, so it's a $3k net loss limit. If you make $100,000 profit from the sale of a stock, but you harvested a tax loss of $103,000, then you'd hit the $3k limit by canceling the $100k profit and having $3k leftover. This $3k max can then be applied towards your personal income, so you can actually reduce tax liability from your normal income this way.
When you book a loss higher than your $3k limit, the additional deductions can still be used by they'll be rolled over to future years. A really bad year without gains to offset may not yield a big tax break right away, but in the future when you make a large gain you could potentially offset it with the old loss.
Although you won't lose extra deductions if you have a net loss more than $3,000, you still to be aware of this information so you don't expect a larger deduction than you'll really receive. In some cases, you may prefer to avoid harvesting a loss if you can't immediately benefit from it.
Wash Sale Rule
The IRS has particular investments that are designated as securities. Stocks, stock options, index funds and ETFs are all considered securities. For any security, there is a wash rule that governs whether you can book a tax loss or not.
For a total period of 61 days, the day you're selling a security plus the 30 days before and after, you're not allow to purchase the same security or a "substantially identical" security. Substantially identical is an IRS term and it isn't explicitly defined either. Using this timeframe, you can't buy a stock and sell it 10 days later to harvest a tax loss. You also can't buy it, sell it for a loss, and then buy it again for 30 days.
The wash sale rule doesn't only apply to a single investment account either. Attempts to get around this rule like having a spouse buy a sold security or using a different brokerage account of yours won't work. The IRS will still identify them as a wash sale and exclude them as a deduction. When a deduction is excluded, the loss will still count towards the future capital gains of your investment when you finally sell it without violating the wash rule.
Tax Loss Harvesting with Cryptocurrency
As of early 2022, the IRS does not currently consider cryptocurrencies like Bitcoin or Ethereum to be securities - they're property. However, capital gains tax still applies to profits that are made from crypto sales. As a result, you can also harvest tax losses from tokens like Bitcoin.
Since the IRS does not consider Bitcoin or other cryptos to be securities, the wash sale rule doesn't apply to them. As a result, you can sell cryptocurrency at a loss and immediate buy it back again, simply to book a loss for tax harvesting purposes.
I wouldn't be surprised at all if this "loophole" ends up getting closed when the government regulates cryptocurrencies in the next year or two. However, right now it is a really popular method for traders to use to avoid paying taxes on their profits. Without worrying about the wash sale rule, you can fairly easily book a loss and still ultimately make a profit from the trade in the end since you can buy it back again right after the sale.
Consult Your Accountant For Advice
Ultimately, it can be a bad idea to attempt tax loss harvesting on your own because it is fairly easy to run afoul of the rules. Violating these rules won't usually get you in trouble with the IRS, but it can land you a much larger tax bill than you had planned to receive.
For this reason, I highly recommend consulting with your tax accountant for advice on how to harvest tax losses legally and effectively to benefit your financial situation. They'll be able to look at your gains and loss for a current year and compare them with your open investments to tell you whether you should sell particular securities before the end of the calendar year to harvest them as a loss for tax purposes.
When used properly and by following the IRS rules, you can gain major tax benefits by utilizing their tax loss harvesting laws. Reduced or completely eliminated income tax liability from capital gains can be achieved with this strategy, but you can also apply up to $3,000 worth of losses as a deduction towards your personal income too.