Tax-loss harvesting
What is Tax-loss harvesting?
Tax-loss harvesting deliberately realizes investment losses to offset eligible taxable gains or income while managing the portfolio's intended exposure.
Optimization should compare the present value of tax deferral with spread, market impact, fees, tracking error, replacement quality, holding-period effects, and future tax rates. Harvested loss is not investment alpha, and a lower current bill can be offset by lower replacement basis and larger later gain.
Backtests must use information and prices available on each trade date, model the restricted period and replacement return, and retain lots across tax years instead of resetting basis annually.
How it works
An investor sells a lot below adjusted basis and may buy a different security to retain similar market exposure. The recognized loss can reduce current tax or become a carryforward, subject to local limitations. The replacement's new basis influences future tax, so much of the benefit is deferral rather than permanent elimination.
Replacement exposure
A substitute should preserve desired asset, sector, factor, duration, or credit exposure without triggering rules that defer the loss. A broad index fund may replace another tracking a different index, but legal similarity tests and tracking behavior require review. Remaining in cash creates opportunity cost if the market rises during a restricted period.
Economic value
Benefit depends on current and future tax rates, offset availability, deferral horizon, compounding, eventual donation or death treatment, and transaction cost. Harvesting a loss that expires unused has little value. Frequent trading can add spreads, fees, taxes, tracking error, operational risk, and short-term gains that offset the intended benefit.
Portfolio constraints
Optimization must respect allocation, concentration, mandate, liquidity, minimum trade size, commissions, fund restrictions, and account interactions. Harvesting should not retain an impaired investment merely for tax timing or replace a carefully selected holding with unsuitable exposure. Coordinated household-level analysis can prevent one account from undermining another account's trade.
Practical process
Maintain reliable lots, estimated tax rates, carryforwards, purchase history, related-account data, and a restricted replacement map. Record thesis, expected benefit, costs, wash-sale review, and later repurchase. Compare realized outcome with a no-harvest counterfactual. Tax rules vary, so generalized software signals require investor-specific professional review.
Sources and further reading
- Capital Gains and Losses, Internal Revenue Service
- Publication 550: Investment Income and Expenses, Internal Revenue Service