Tax-Loss Harvesting: Definition & How It Improves Your Tax Return
Have you ever invested in something, such as a stock or bond, and just missed the optimal selling time? Or, have you ever sold an investment and then had to pay a large amount of capital gains tax? There are several moving parts to an investment strategy. You need to think about tax implications from short-term and long-term capital gains, and even long-term capital losses.
A tax-loss harvesting strategy can be effective to help you find the most timely selling of a security you own. Plus, it can help you avoid additional losses. We put together this guide to help you better understand how tax-harvesting works. We’ll also dive into the benefits, some rules to know, and how it can work with cryptocurrencies.
Table of Contents
- Tax-loss harvesting is a tactic to help reduce the total amount of capital gains tax that’s owed on the sale of a security.
- Tax-loss harvesting refers to the timely sale of a security at a loss.
- The maximum amount a taxpayer can write off for capital gains losses is $3,000 for a single tax year.
- IRS rules prohibit taxpayers from carrying forward extra losses to some time in the future.
What Is Tax-Loss Harvesting?
In order to reduce the amount of capital gains tax owed on the sale of other securities at a profit, tax-loss harvesting refers to the timely sale of securities at a loss.
Since short-term capital gains are typically taxed at a greater rate than long-term capital gains, this method is most frequently employed to reduce the amount of taxes owed on those gains. Long-term capital gains could, however, also be offset using this strategy.
This tactic can lower the expense of capital gains taxes while preserving the value of the investment professional’s portfolio. This can be one of the biggest benefits to harvesting losses.
The maximum amount of capital gains losses that a federal taxpayer may write off during a single tax year is $3,000. However, IRS regulations permit extra losses to be carried forward into future tax years.
How Does Tax-Loss Harvesting Work?
Tax-loss selling is another name for tax-loss harvesting. Although it may be done at any time of the year, most investors wait until the end to evaluate the performance of their portfolios over the previous year and how that would affect their taxes.
An investment that has lost value might be sold using the tax-loss harvesting technique in order to receive a credit against the profits from other investments.
Tax-loss harvesting is a vital strategy for many investors to lower their overall taxes. Tax-loss harvesting can decrease the severity of the loss even though it cannot put an investor back in their previous position. To balance the increase in the price of Security B, for instance, a decrease in the value of Security A might be sold.
Tax-Loss Harvesting Rules to Know
Profiting from the fact that capital losses can be used to offset capital gains is known as tax-loss harvesting. In order to pay less capital gains tax on lucrative assets sold throughout the year, an investor can “bank” capital losses from unsuccessful investments.
This tactic entails buying similar investments with the profits from selling the unproductive ones in order to maintain the overall balance of the portfolio.
According to IRS regulations, if a loss is used to reduce capital gains taxes, the investor is not permitted to purchase the same investment within 30 days. When you record your tax-loss harvesting, you use Form 8949 and Schedule D of Form 1040. From here, there are two main things to keep in mind.
The first rule has to do with the wash sale rules. In this case, if you and your spouse invest in a stock or fund that’s similar or identical within 30 days to an investment you sold previously, any loss incurred is disallowed.
The second rule has to do with cost basis calculations. Here, keeping accurate and well-maintained records is important to determine the proper cost basis when you need to report it to the IRS.
Tax-Loss Harvesting with Cryptocurrencies
Simply said, cryptocurrency tax loss harvesting is an investing technique that lowers net capital gains and, as a result, lowers your tax burden for the fiscal year. Here is how cryptocurrency tax loss harvesting functions.
The tax office considers any bitcoin sale, exchange, expenditure, or even gifting (depending on where you live) to be the disposal of a capital asset. Similar to selling stocks or rental properties. If you sell this asset, you’ll either lose money or make money. This can be calculated by deducting your cost basis from the asset’s price on the day you sold it.
If you sell something for a profit and make a capital gain, you must pay capital gains tax on that profit. You don’t have to pay taxes on capital losses. You can actually subtract your net capital losses from your overall net capital gain.
Your net capital gain is the sum of all of your capital profits during the fiscal year, whereas your net capital loss is the sum of all of your capital losses during the fiscal year.
Both your net capital gain and net capital loss must be reported when you file your taxes as part of your annual tax return. The remaining amount is the amount you’ll pay after deducting your net capital gain from your net capital loss.
Basically, Crypto tax loss harvesting is the practice of selling cryptocurrency at a loss in order to generate a capital loss that can be used to offset capital gains. This helps lower an investor’s overall tax burden. Then, they might repurchase the asset at a lower cost in order to hold onto it for potential future returns.
Example of Tax-Loss Harvesting
Let’s say an investor has revenue that qualifies them for the highest rate of capital gains tax. That entails more than $445,851 for solo filers and $501,601 for married couples filing jointly for the 2021 and 2022 tax years.
The investor realized long-term capital gains on the sale of investments, which are subject to a 20% tax rate. The following details show the investor’s annual trading activity, portfolio gains, and losses:
- Mutual Fund A: 450 days of holdings with an unrealized gain of $250,000.
- Mutual Fund B: $130,000 in unrealized losses held for 635 days
- Mutual Fund C: Held for 125 days with an unrealized loss of $100,000.
Buying and Selling
- Mutual Fund E: It was sold and made a profit of $200,000. The money was kept for 380 days.
- Mutual Fund F: Sold; profit of $150,000 obtained. The money was kept for 150 days.
These sales have the following tax due:
Tax without harvesting = ($200,000 x 20%) + ($150,000 x 37%) = $40,000 + $55,500 = $95,500
The sales would serve to balance the gains if the investor sold mutual funds B and C to harvest losses, and the tax due would be:
Tax with harvesting is calculated as follows:
Tax with harvesting = (($200,000 – $130,000) x 20%) + (($150,000 – $100,000) x 37%) = $14,000 + $18,500 = $32,500
Profiting from the fact that capital losses can be used to offset capital gains is known as tax-loss harvesting. In order to pay less capital gains tax on lucrative assets sold throughout the year, an investor can bank capital losses from unsuccessful investments. It can be a balanced strategy to get a better capital-gains tax rate, federal tax rate, and marginal rate.
In order to maintain the overall balance of the portfolio, this method calls for using the money generated from selling the losing investments to purchase similar investments. This helps with growth funds and it’s a worthwhile strategy for fund investors.
According to IRS regulations, if a loss is used to reduce capital gains taxes, the investor is not permitted to purchase the same investment within 30 days. This could be for an individual stock, a company stock, or other individual securities, for example. Speak to your financial advisor or tax advisor if you require assistance.
FAQs About Tax-Loss Harvesting
When Should I Do Tax Harvesting?
Typically, tax-loss harvesting is a good strategy for your portfolio once your annual income exceeds $100,000 and if you don’t plan on making withdrawals within 12 months. It can depend on the capital loss tax deduction and whether you have harvested short-term losses.
Is There a Limit to Tax-Loss Harvesting?
The maximum capital gains tax amount you can write off in a single tax year is $3,000. There are also rules around identical securities, unused losses, asset allocation, and short-term losses. You should also familiarize yourself with taxable investment gains and other types of gains.
How Long Can You Tax Loss Harvest?
It depends on the security. For example, long-term losses might be able to be carried into a future year. For a $9,000 loss, this would get spread out over three years. This helps avoid both short- and long-term losses for extra investment gains.
Is Tax Gain Harvesting Worth It?
Tax-loss harvesting can provide excellent returns and benefits if you use it to help reduce your income. This is because tax rates for income are often higher compared to tax rates for long-term capital gains. It can be a good way to avoid investment losses and reduce taxable income.
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