What it is:

How it works/Example:

John Doe made two major investment transactions this year:

1. Sold 1,000 shares of Company XYZ at $25 a share (originally purchased five years ago for $15 a share )

2. Sold 1,000 shares of Company ABC at $40 a share (originally purchased five years ago for $20 a share )

These two transactions created $30,000 of profit. for which he will have to pay capital gains tax of, say, 15%, or $4,500.

In order to reduce that hefty tax bill, John Doe could also use this as an opportunity to unload some of the dog stocks that he’s been hanging onto. For instance, John Doe might own 200 shares of Company DEF, which he bought for $30 a share and are now laying there at $15 a share with little hope of recovery. If John Doe sells those shares. he’ll take a loss of $15 x 200 = $3,000.

This loss is tax-deductible. Thus, if John Doe wants to lower his tax bill, he might as well sell his dog stock now and reduce his taxable gains. Accordingly, instead of paying $4,500 in taxes. John Doe would pay:

Capital Gains tax, post-harvesting = ($30,000 — $3,000) x 15% = $4,050

Looks like unloading his dogs now would save him $450 in taxes. Note. however, that John Doe will also incur transaction fees to effect these transactions, which would reduce his tax savings.

Why it Matters:

Generally, the rule is that investors must net short-term gains and losses against each other, and net long-term gains and losses against each other. The IRS typically limits the deduction for capital losses to $3,000 a year .

In our example, we assume that John Doe is dealing with a long-term capital gains rate of 15%. Other situations might be different, but the point is that investors who have considerable capital gains tax obligations can offset those obligations by unloading investments in which they’ve lost money during the same tax year. IRAs, 401(k)s, and other tax-sheltered plans usually do not permit tax-loss harvesting ; shares of mutual funds and ETFs. however, are well-suited for tax-loss harvesting.

It is important to note that the IRS is aware that the deductibility of investment losses might tempt investors to sell at a loss, deduct the loss, and then turn around and buy the same stock again (in an effort to evade taxes ). This practice is called a wash sale — the IRS disallows investors from taking deductions associated with them.