Tax-Loss Harvesting: A Silver Lining Tactic

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In times of market volatility, investors often experience pain and heightened anxiety — particularly as markets drop. However, volatile periods also present silver linings in the form of opportunities, not the least of which is tax-loss harvesting. Recognizing losses in a portfolio when the market is depressed can offset capital gains this year or be carried forward until the investor has capital gains in the future. Moreover, some of the capital losses can be used to offset ordinary income. Tax-loss harvesting is a tool that can be used whether a portfolio as a whole is up or down in a particular year, as there are nearly always individual investments that underperform even in bullish markets. While taxes should not be the primary consideration in investment decisions, tax-loss harvesting is a good thing to keep in mind for an investor seeking to rebalance their portfolio in light of recent market performance.

What Is Tax-Loss Harvesting?

Tax-loss harvesting is when a taxpayer identifies and sells capital assets with built-in losses to offset capital gains that will be taxable this year or, if carried forward, to offset capital gains in future tax years. Capital losses can also offset up to $3,000 in ordinary income. While many investors think of this as a fourth quarter activity, it can be done any time during the year. Volatile markets can present more opportunities to identify and recognize losses. However, given the tax implications, investors should consult their tax advisors when undertaking tax-loss harvesting.

Tax-loss harvesting accelerates the loss deduction into the current year. If a taxpayer does not “harvest” a loss and the value of the asset stabilizes, the built-in loss can be recognized and deducted later, so this is not a “use it or lose it” situation. However, accelerating the loss into a particular year can be useful when a taxpayer has an unusual or unexpected capital gain that, for example, would push them into a higher income tax bracket or disqualify them for another income-based tax benefit. Another situation where it can be helpful is when a taxpayer is moving from a high-income-tax state to a lower- or no-income-tax state — In this situation, the state-level benefit is more valuable in the year the taxpayer is living in the high-income-tax state. Furthermore, in a volatile market there may be opportunities to take advantage of temporary losses that might be erased when stock prices recover.

Example:

In July, 2024, Ivan purchased one thousand shares each of Microsoft, UPS, McDonald’s, AT&T, U.S. Steel, and General Motors in his taxable investment account. In April 2025, Ivan sold these shares.

In this example, Ivan has $92,500 in short-term capital losses. In addition, he has $74,250 in short-term capital gains. The losses will offset all of the gains. In addition, Ivan can deduct $3,000 of his losses against his 2025 ordinary income. This leaves $15,250 in short-term capital losses that can be carried forward.

But What If the Taxpayer Wants to Keep Those Investments?

Sometimes, the assets with built-in losses are assets, or classes of assets, that the investor wants to retain in their portfolio. Can they rebuy the securities after they sell them to maintain their desired exposure? This is where the wash-sale rules come into play, imposing limits on when and how a taxpayer can reinvest.

The wash-sale rules will deny the loss if the taxpayer purchases the same or a “substantially identical” asset within a period starting thirty days before the sale and ending thirty days after the sale (a total period of 61 days). This would mean the taxpayer in our example could not purchase Microsoft, UPS, McDonald’s, AT&T, U.S. Steel or General Motors shares during the 61-day period if they wished to avoid the wash-sale rules, but they could purchase different assets within that period. They would be able to purchase additional shares in those companies if they wait until the wash-sale window has closed (for example, 40 days after the harvesting sale). Note that the wash sale may occur unintentionally — by receiving shares of employer stock in compensation after you sold those shares in a portfolio, or by having one investment manager sell the shares in a managed account and a different manager buy them independently.

How different does that new asset have to be to avoid the “substantially identical” rule? Assets that are not considered substantially identical for purposes of the wash-sale rule include:

• Stocks of different companies in the same industry. Our sample taxpayer could replace the GM stock by buying Ford¹
• Common and preferred stock in the same company²
• Bonds issued by one issuer, but with different maturity dates and different interest rates

If an investor sells one S&P 500 exchange-traded fund (ETF) and buys another one from another fund manager, are they substantially identical? ETFs with different characteristics can avoid the wash sale rule, but if the purchase and sale are ETFs tied to the same index (e.g., An S&P 500 fund from one manager is sold and another manager’s S&P 500 fund is purchased), there is a wash sale because the two funds will own exactly the same shares. In such circumstances, consider purchasing an ETF that has a different asset mix, such as a large cap growth fund, to avoid application of the wash-sale rule.

Examples of transactions that will be treated as wash sales:

• Selling an employer security, then receiving shares in the same company as a bonus
• Selling stock in one account, then buying the same stock through another account, including an IRA or an account in the name of your spouse
• Selling a security, then buying an option to purchase the same security
• Selling a security, then purchasing bonds or preferred stock that is convertible into the same security that the taxpayer sold

Note that in a reorganization, the shares of the old company and the new company are treated as substantially identical and therefore are subject to the wash-sale rules.

What Are the Tax Consequences of a Wash Sale?

When a taxpayer has a wash sale, the IRS will deny the deduction for the intended sale, meaning that the taxpayer’s attempt to harvest a tax loss will fail. Because the taxpayer cannot recognize the loss, it will be added to their basis in the newly acquired asset.