Tax-Loss Harvesting

Definition

Tax-loss harvesting (TLH) is the realization of investment losses to offset capital gains or ordinary income while maintaining equivalent market exposure through substitute securities. The strategy exploits the asymmetric timing of loss recognition and cost basis adjustment.

tax_benefit = harvested_loss * marginal_tax_rate

IRS Rules: Up to $3,000 in net capital losses can offset ordinary income annually. Excess losses carry forward indefinitely to offset future gains or income.

The key insight: TLH isn't about avoiding taxes forever — it's about deferring them and potentially converting high-rate gains (short-term, at ordinary income rates) into low-rate gains (long-term, at 0-20%). The time value of tax deferral plus potential rate conversion creates real value.

Execution Process

Tax-Loss Harvesting Steps

1 Identify unrealized loss: Position purchased at $200/share now trading at $170. Unrealized loss = $30/share.

2 Sell to realize loss: Sell position, converting unrealized loss to realized loss for tax purposes.

3 Purchase substitute security: Immediately buy similar (not substantially identical) fund to maintain market exposure.

4 Claim tax benefit: Use loss to offset gains or up to $3k ordinary income on tax return.

Wash Sale Rule

IRS disallows loss deduction if a substantially identical security is purchased within 30 days before or after the sale (61-day window total):

Not a Penalty: Wash sales are not illegal or a fee. The disallowed loss simply adds to the cost basis of the replacement security. You still get the tax benefit — just later when you sell the replacement. It's a deferral mechanism, not a punishment.

Monthly Trading Simplification: If you only trade once per month (e.g., monthly rebalancing), wash sales become largely irrelevant. With 30+ days between transactions, you naturally avoid the wash sale window. The rule primarily affects frequent traders and automatic dividend reinvestment.

Substitute Security Selection

The art of TLH lies in finding securities that maintain your intended exposure while being "different enough" to avoid wash sale treatment. The IRS hasn't defined "substantially identical" precisely, but these patterns are generally accepted:

Common TLH Swap Pairs

VOO ↔ SPY ↔ IVV — All S&P 500, but different fund families. Some argue these are substantially identical; others disagree. Consult tax advisor.
VTI ↔ ITOT ↔ SCHB — Total US Market funds from different providers. Generally considered safe swaps.
VXUS ↔ IXUS ↔ SCHF — International developed markets. Different providers, similar exposure.
Individual tech stock → QQQ or VGT — Selling AAPL at a loss, buying tech sector ETF for similar exposure.
VTI → VOO — Total Market to S&P 500. Different indices (3,800 stocks vs 500), clearly not identical.

The key principle: similar exposure, different security. You want to stay invested in the market while harvesting the loss. Selling tech stocks and buying a tech ETF maintains your sector bet without triggering wash sale on the individual stock.

Direct Indexing

Direct indexing is an advanced TLH strategy where you hold individual stocks to replicate an index rather than owning an ETF. This creates hundreds of individual tax lots, each with its own cost basis — dramatically increasing harvesting opportunities.

How It Works: Instead of holding VTI (one position), you hold 500+ individual stocks in S&P 500 weights. When any single stock drops, you can harvest that loss while the overall portfolio tracks the index. Some estimates suggest 1-2% annual tax alpha from aggressive direct indexing.

Pros: Maximum harvesting opportunities, no wash sale concerns (each stock is unique)
Cons: Significant complexity, requires automation or robo-advisor, higher trading costs, basis tracking nightmare
Best for: High net worth taxable accounts ($500k+) where tax savings justify complexity
Providers: Wealthfront, Betterment, Fidelity, Schwab offer direct indexing services

Diminishing Returns: Direct indexing benefits decrease over time as your cost basis rises. Most valuable in early years of a taxable portfolio when you have fresh cost basis to work with.

Tax Mathematics

Example scenario with $10,000 capital gains and $8,000 harvestable losses:

TLH Tax Savings Calculation

Net taxable gain = $10,000 - $8,000 = $2,000
Tax saved at 15% LTCG = $8,000 * 0.15 = $1,200

Scenario with excess losses ($15,000 losses, $5,000 gains):

Excess Loss Carryforward

Offset gains: $5,000 → saves $750 (at 15% LTCG)
Offset income: $3,000 → saves $660 (at 22% ordinary)
Carry forward: $7,000 → offsets future gains

Timing Considerations

Market downturns: Volatility creates harvesting opportunities
Year-end review: Assess portfolio before December 31
After gains realization: Harvest losses to offset gains from rebalancing or selling
New contributions: Avoid buying substantially identical securities in any account within wash sale window

Limitations

Deferred, Not Eliminated: TLH lowers cost basis in the replacement security. Future sale will have larger gain — benefit is time value of tax deferral, not permanent avoidance.

Taxable accounts only: IRAs and 401ks have no capital gains tax — TLH inapplicable
Basis tracking complexity: Multiple lots require careful record-keeping
Transaction costs: Commissions and spreads reduce net benefit (mostly eliminated with zero-commission trading)
Wash sale across accounts: Buying in IRA within 30 days also triggers wash sale

Informational Only

Chubby doesn't yet model lot-level capital gains or tax-loss harvesting. This page explains concepts only.