Tax Loss Harvesting
Tax loss harvesting refers to realizing losses to offset realised gains or other taxable income. Loss harvesting reduces the taxes due now but it generally does not reduce eventual total taxes.
If the benefit is taken now to lower taxes now, it cannot be used in the future and taxes in the future will be higher. Even so, loss harvesting is beneficial. Think of it as saving $1 in taxes now versus paying $1 at a future date.
On this page, we use a numerical example to illustrate the benefits of harvesting tax losses. One of the reasons that loss harvesting is beneficial is the fact that the tax savings can be reinvested, thereby increasing the investor’s total return. Loss harvesting is closely related to highest-in/first-out tax lot accounting.
Tax loss harvesting example
An investor has a realized capital gain of $100,000 and pays a capital gains tax rate of 20%. The investor is considering selling stock A to reduce his tax bill. Stock A has a cost basis of $120,000 and has fallen to a current market value of $80,000.
Let’s consider two cases and their impact on taxes due:
- If stock A is not sold, the investor will have to pay capital gains taxes on the full capital gains, leading to a tax of 0.2 x $100,000 = $20,000.
- If stock A is sold, there is a capital loss of $40,000. This loss can be used to offset part of the gain, such that the taxable gain is only $60,000. The tax bill will then equal 0.2 x $60,000 = $12,000. Thus, there is a tax saving of $6,000.
When a loss is harvested by the investor, the proceeds are immediately available and are typically reinvested, and the reinvested sale proceeds become the (new) lower cost basis. When the new asset is eventually sold, there is a higher realised gain (or lower loss) for higher tax due (or less tax sheltering) in the future. Taking the loss now means that the loss amount is unavailable in the future. Also note that, since the tax savings can be reinvested, it increases the investor’s ending wealth considerably.
We discussed how tax loss harvesting rules in a country allow investors to lower the tax bill on capital gains, thereby increasing their ending wealth by reinvesting the tax savings.