You may be considering taking some losses this year, given the stock market’s performance this year. When you decide to do this, you are utilizing a process known as tax loss harvesting. When investments in a taxable account decline, it’s an excellent strategy to consider taking a loss, but there are some pitfalls to avoid. Tax loss harvesting involves selling investments in taxable accounts with paper losses so that investors can deduct those losses from their taxes when they file their returns.
Your capital losses for the year will offset any capital gains you report on your tax return. You can recognize capital gains tax-free for every dollar of taxable loss you recognize. Excess losses can be deducted up to $3,000 against other income on your tax return if the amount of your capital losses exceed the amount of your capital gains for the year. It is possible to carry over capital losses from one year to the next if they exceed capital gains plus the $3,000 deduction for the year.
By selling a losing investment, other gains can be protected from income taxes, and the capital can be invested elsewhere.
Most likely, you bought the investment because you expected it to appreciate. If you like the investment’s long-term prospects after selling it, you can purchase it back. The wash sale rule, however, should be avoided. You cannot deduct a declining stock loss if you have acquired the same or a “substantially identical” share/stock within 30 days of the sale. The loss isn’t deductible if you don’t wait long enough. It is added to the basis of the new investment. The deduction will be delayed until the investment is sold.
If you violate the wash sale rule, there may be a silver lining. A disallowed loss is added to the cost basis of the replacement stock. You will have a smaller taxable gain or a larger deductible loss when you sell the replacement stock. The holding period for the initial stock is now included in the holding period applied to the new stock. Therefore, any gain from selling the new stock will be taxed at the lower long-term capital gains rate if you sell it.
Upon the sale of an investment, you can buy an investment that isn’t substantially identical within 30 days. You can, for example, sell one tech stock and buy another within the same sector. Alternatively, you can sell your biotech stock and invest in a biotech ETF.
You cannot buy a substantially identical investment in an IRA or 401(k). According to the IRS, individual investors who sell investments in taxable accounts and repurchase them in IRAs or 401(k)s within 30 days violate the wash sale rule. It’s one of the few cases where an IRA isn’t considered a separate taxpayer.
Here’s another related point. You can’t deduct a loss from an IRA investment on your tax return when you have a losing investment. Losses in IRAs can be deducted only if all your IRAs of the same type (traditional or Roth) have been fully distributed and the proceeds are less than your aggregate cost basis.