What Is Tax Loss Harvesting and How Does It Work?

Tax loss harvesting is an investing strategy that takes advantage of a specific feature of how investment gains and losses are taxed — by intentionally selling investments that have declined in value to realize a loss, which can then be used to offset taxes owed on gains elsewhere in your portfolio, or in some cases against ordinary income. While the term sounds technical, the underlying concept is something many investors can apply, particularly in taxable brokerage accounts where this strategy is relevant — it does not apply to tax-advantaged accounts like 401k or IRA accounts, where gains and losses are not taxed in the same way.

How Capital Gains and Losses Work

When you sell an investment for more than you paid for it, you realize a capital gain, which is generally taxable. When you sell an investment for less than you paid, you realize a capital loss. These gains and losses can offset each other — if you have $5,000 in gains from selling one investment and $3,000 in losses from selling another, your net taxable gain is $2,000 rather than the full $5,000. This offsetting is the foundation of tax loss harvesting: by realizing losses, you reduce the net gains that are subject to tax.

Offsetting Ordinary Income

If your capital losses exceed your capital gains in a given year, a portion of the excess loss — up to a specific annual limit — can be used to offset ordinary income, such as wages, reducing your overall taxable income for the year. Any losses beyond that annual limit can typically be carried forward to future years, continuing to offset gains or income in those future years until the loss is fully used.

The Wash Sale Rule — The Critical Catch

The most important rule to understand with tax loss harvesting is the wash sale rule, which prevents you from claiming a tax loss if you buy the same or a "substantially identical" investment within a window of 30 days before or after the sale that generated the loss. This rule exists specifically to prevent investors from selling an investment purely to generate a tax loss while immediately buying it back to maintain the same investment position — which would otherwise allow harvesting losses with essentially no change to your actual portfolio. If a wash sale occurs, the loss is disallowed for tax purposes, though it gets added to the cost basis of the repurchased investment, effectively deferring rather than eliminating the benefit.

Maintaining Your Investment Strategy While Harvesting

Because of the wash sale rule, investors who want to harvest a loss while staying invested in a similar way often sell the investment that has declined and immediately purchase a similar but not "substantially identical" investment — for example, selling one broad market index fund and purchasing a different broad market index fund from a different provider that tracks a similar but not identical index. This maintains similar market exposure during the 30-day window while avoiding the wash sale rule, though what counts as "substantially identical" is not always perfectly clear-cut, which is part of why this strategy benefits from careful execution.

When Tax Loss Harvesting Is Most Relevant

Tax loss harvesting is most relevant for investors with taxable brokerage accounts holding individual stocks or funds that have experienced declines, particularly during broader market downturns when many positions may show losses simultaneously. For investors who hold all their investments in tax-advantaged retirement accounts, this strategy is not applicable, since those accounts do not generate the kind of taxable gains and losses that harvesting addresses.

The Long-Term Perspective

While tax loss harvesting can provide genuine tax benefits, it should generally be viewed as a secondary consideration to your overall investment strategy — selling an investment purely to harvest a loss, if it disrupts an otherwise sound long-term allocation, may not be worth the tax benefit. The strategy works best when it can be executed in a way that maintains your intended investment exposure while capturing a tax benefit from a decline that has already occurred, rather than driving investment decisions that would not otherwise make sense.