Tax Loss Harvesting

Tax-Loss Harvesting

Core Concepts

Candidate Identification

Scan the portfolio for positions with unrealized losses that meet all three filters:

• Materiality threshold: Minimum absolute loss (e.g., $2,000) or minimum loss-to-value ratio (e.g., loss exceeds 5% of position market value). Harvesting a $200 loss on a $50,000 portfolio is not worth the operational cost.
• Holding period filter: Positions held less than 31 days may not have meaningful losses and create short-term wash-sale complexity. Positions approaching the one-year mark (days 335-365) may benefit from waiting to convert a short-term loss into a long-term loss only if the position is expected to continue declining.
• Loss magnitude ranking: Rank candidates by Tax Benefit = Unrealized Loss * Applicable Tax Rate. Prioritize short-term losses (taxed at ordinary rates up to 37%) over long-term losses (taxed at capital gains rates of 15-20%) when gain/loss budget allows.

Gain/Loss Budgeting

Before harvesting, build the year-to-date tax budget:

1. Realized gains YTD: Sum all short-term and long-term capital gains already realized (including fund distributions).
2. Planned gain exposure: Estimate gains from pending rebalancing trades, planned liquidations, or expected fund capital gain distributions.
3. Loss carryforward balance: Check prior-year unused capital loss carryforwards (these offset gains before new harvests do).
4. Target harvest amount: Target Harvest = (Realized Gains YTD + Planned Gains) - Loss Carryforward + $3,000 ordinary income offset. Harvesting this amount offsets all expected gains AND captures the full $3,000 annual deduction against ordinary income; harvest more to build carryforward for future years.

Replacement Security Selection

The replacement must maintain market exposure without being "substantially identical":

• ETF-to-ETF swaps: Switch between funds tracking different indices (e.g., Vanguard Total Stock Market to Schwab Broad Market, or S&P 500 to Russell 1000). Different index methodology is generally sufficient.
• Individual stock replacement: Replace a single stock with a sector ETF or a peer company. Example: sell Apple, buy Technology Select Sector SPDR (XLK).
• Tracking error budget: The replacement should have a correlation of 0.95+ and tracking error under 2% annualized relative to the original holding. Wider tracking error is acceptable for larger tax benefits.
• Expense ratio delta: Ensure the replacement does not have meaningfully higher expenses. A 10 bps cost increase on a $100K position held for 30 days costs roughly $8 — negligible against a $2,000+ tax benefit.

Wash-Sale Compliance

The wash-sale rule (IRC Section 1091) disallows a loss if a substantially identical security is acquired within the 61-day window (30 days before + sale date + 30 days after):

• Cross-account scope: The rule applies across ALL accounts owned by the taxpayer: taxable brokerage, Traditional IRA, Roth IRA, 401(k), HSA, and spouse's accounts. A purchase in any of these accounts triggers wash-sale disallowance.
• IRA wash-sale trap: If a wash sale is triggered by a purchase in an IRA, the disallowed loss is permanently lost — it cannot be added to the IRA cost basis. This is the most dangerous wash-sale scenario.
• DRIP suspension: Automatic dividend reinvestment (DRIP) in the sold security or a substantially identical fund must be suspended during the 61-day window. Reinvesting even a small dividend triggers a partial wash sale.
• Spouse coordination: Purchases in a spouse's accounts (including retirement accounts) trigger wash-sale rules. Both spouses' automatic investments, 401(k) contributions, and DRIP settings must be reviewed.

Execution Planning

Translate candidates into an actionable trade list:

• Lot selection method: Use Specific Identification (Spec ID) to select the highest-cost-basis lots first (HIFO). This maximizes the realized loss per share sold. If only partial harvesting is needed, sell only the lots with cost basis above current market price.
• Coordination with rebalancing: If the portfolio also needs rebalancing, combine TLH sells with rebalance sells to reduce total trade count. A position that is both overweight and at a loss is the ideal candidate — the harvest and rebalance are the same trade.
• Timing strategy: Year-end harvesting (October-December) captures the full year's losses but faces market timing risk. Opportunistic harvesting throughout the year during drawdowns of 5%+ captures losses that may recover by year-end.
• Trade list fields: Security, account, action (sell/buy), shares, lot IDs, estimated loss, replacement security, wash-sale window start/end dates.

Tax Savings Calculation

Quantify the dollar value of each proposed harvest:

• Federal rate selection: Short-term losses offset short-term gains first (up to 37% ordinary rate). Long-term losses offset long-term gains (15-20% rate). Net losses of either type can cross over to offset the other, then up to $3,000 offsets ordinary income.
• State tax impact: Most states tax capital gains as ordinary income (rates range from 0% up to California's top statutory rate on investment income of 13.3%; California's effective top rate on wage income is 14.4%+ since the 2024 SDI uncapping). Include state tax savings in the calculation; for a California resident at the 13.3% bracket, state tax roughly doubles the benefit of each harvest.
• NIIT interaction: The 3.8% Net Investment Income Tax (IRC Section 1411) applies to the lesser of net investment income or MAGI exceeding $250,000 (MFJ) — a statutory threshold that is not inflation-indexed. Harvested losses reduce net investment income, potentially eliminating NIIT exposure.

Post-Harvest Monitoring

After executing the harvest:

• Wash-sale window tracking: Maintain a calendar of open wash-sale windows with security identifiers and expiration dates. Flag any pending purchases (including automated ones) that would violate the window.
• Replacement performance: Monitor tracking error between the replacement and original security. If the replacement significantly underperforms (>3% divergence), evaluate whether the tax benefit justified the swap.
• Cost basis updates: Verify that broker statements reflect the new (lower) cost basis on replacement securities. The replacement's basis equals purchase price, not the original security's basis.
• Swap-back timing: After the 31st day, the investor may sell the replacement and repurchase the original security if desired. Evaluate whether the swap-back itself triggers a taxable gain on the replacement position.

Household-Level Coordination

TLH across a household with multiple accounts requires centralized tracking:

• Account type matrix: Taxable accounts are the only accounts where TLH generates direct tax benefits. Retirement accounts have no realized gains/losses for tax purposes, but they can trigger wash sales in taxable accounts.
• Advisor-managed vs held-away: If the client has accounts at other institutions (401(k) plan, outside brokerage), the advisor cannot control purchases. Document held-away holdings and instruct the client to avoid purchasing substantially identical securities during open wash-sale windows.
• Spousal coordination checklist: (1) Review spouse's 401(k) fund lineup for overlap, (2) suspend DRIP in spouse's accounts for harvested securities, (3) coordinate any year-end tax trades across both spouses.

Key Formulas

Worked Examples

Example 1: Single Position Harvest with Replacement Selection

Given:

• Client holds 500 shares of XYZ Corp purchased at $80/share ($40,000 cost basis), current price $62/share ($31,000 market value), held 8 months (short-term)
• Client has $12,000 in short-term realized gains YTD, marginal federal rate 35%, state rate 9.3%, NIIT applies (3.8%)
• Replacement candidate: Sector ETF (correlation 0.97, tracking error 1.4% annualized, expense ratio 0.10% vs 0% for individual stock)

Calculate: Tax benefit, net tax alpha, and break-even holding period for the replacement.

Solution:

1. Unrealized loss: $31,000 - $40,000 = -$9,000 (short-term)
2. Applicable rate: 35% federal + 9.3% state + 3.8% NIIT = 48.1% combined
3. Tax benefit: $9,000 * 48.1% = $4,329
4. Transaction costs: Commission $0 (zero-commission broker) + estimated spread cost 0.05% * $31,000 * 2 trades = $31
5. Tracking error cost: 1.4% annualized * $31,000 * (30/365) = $36 (for the 30-day minimum hold)
6. Net tax alpha: $4,329 - $31 - $36 = $4,262
7. Annual cost of replacement: $31,000 * (0.10% expense + 1.4% tracking error drag estimate of 0.05%) = $46.50/year
8. Break-even holding period: $4,262 / $46.50 = 91.7 years — the tax benefit overwhelmingly justifies the swap
9. Action: Sell XYZ Corp (Spec ID, all lots), buy Sector ETF. Set wash-sale window reminder for 31 calendar days. Suspend any XYZ DRIP in all household accounts.