What is Tax-loss harvesting?

Tax-loss harvesting means selling investments at a loss to offset the tax on gains from other investments. It’s a way to reduce your tax bill. Under IRS rules, capital losses must first be used to offset capital gains of the same type (short-term losses offset short-term gains, and long-term losses offset long-term gains). Any excess net losses can then offset the other type of gain.

If a taxpayer's net capital losses exceed their net capital gains for the year, they can use up to $3,000 of the excess losses ($1,500 if married filing separately) to offset ordinary income on their Form 1040. Any remaining capital losses can be carried forward indefinitely to future tax years, preserving their tax-reducing value.

To prevent abuse, the IRS enforces the 'wash-sale rule' under Section 1091. This rule disallows the tax loss if the taxpayer purchases the same or a 'substantially identical' security within 30 days before or after the sale. If a wash sale occurs, the loss is disallowed and added to the cost basis of the newly purchased security.