Turning a loss into a deduction
Sell a losing position, buy something similar, and the paper loss becomes a deduction without changing the exposure. What it really buys is time.
- Apply a harvested loss against gains, then income, then carry the rest forward
- Find the loss needed to cut a tax bill by a given amount
- Value the deferral when the tax comes back later
- Say what the wash-sale rule allows and what it does not
The intuition
A client bought a fund for $100,000; it is worth $75,000. Selling it and buying a similar fund with the proceeds leaves their market exposure where it was and creates a $25,000 realized loss. Under the simplified rules here, that loss offsets realized capital gains first, then up to $3,000 of ordinary income, and anything left carries forward. With $20,000 of gains taxed at 20% and income taxed at 32%, the harvest saves $4,960 this year and carries $2,000 forward.
It is not free money. The replacement fund now has a lower cost basis, so the loss comes back as a bigger gain when it is finally sold. What harvesting really buys is time: tax is paid later instead of now, the saved tax compounds in the meantime, and if the rate is lower later, or the position is never sold, the deferral becomes a permanent saving. The traps are the wash-sale rule and forgetting that losses offset gains before ordinary income.
Loss = cost basis − market value. Tax saved = min(loss, gains) × capital-gains rate + min(remaining loss, $3,000) × income rate; the rest carries forward. Loss needed to save X against gains = X ÷ capital-gains rate. Deferral benefit at the same rate later = tax saved × ((1 + r)ᵏ − 1).
Why it works
- The conventions here: simplified US-style rules, stated in the prompts. A realized loss offsets this year's realized capital gains first, at one capital-gains rate; then up to $3,000 of ordinary income, at the income rate; the rest carries forward. The replacement is similar, not substantially identical, bought at the same price. The deferral ask assumes the whole loss offsets gains now and the extra gain is taxed at the same rate later, with the tax saved invested at a stated after-tax return.
- Order matters, and so does the rate on each slice. Gains first at the capital-gains rate; then $3,000 of income at the higher income rate; then the carry-forward, which is worth nothing until it is used. Because income is taxed at the higher rate, a dollar of loss is worth more against income than against gains, so a year with more gains can save less tax on the same loss.
- The carry-forward never expires for an individual, but at $3,000 a year against income it can take decades. Its real value is the future gains it can absorb: rebalancing trades, or selling a concentrated position.
- The deferral is the benefit, not the deduction. At the same rate later, the tax comes back in full when the replacement is sold; what is left is the return the saved tax earned in the meantime.
- It becomes permanent when the rate is lower later, when the shares are donated, or when they are held until death and the heirs receive a stepped-up basis. It is also better than a pure deferral when today's loss offsets income taxed at a higher rate than the future gain.
- The wash-sale rule disallows the loss if substantially identical securities are bought within 30 days before or after, including in the client's IRA or a spouse's account. A different index fund tracking the same index is the usual replacement.
| Loss: $100,000 − $75,000 | $25,000 |
| Against gains: $20,000 × 20% | $4,000 |
| Against ordinary income: $3,000 × 32% | $960 |
| Tax saved this year | $4,960, with $2,000 carried forward |
| Loss needed to save $5,000 against gains: 5,000 ÷ 20% | $25,000 |
| Deferral benefit if the full $25,000 offset gains: $5,000 × (1.06¹⁰ − 1) | $3,954 |
The deferral benefit is what $5,000 of tax earned over ten years before it was paid back. If the client's rate is lower when the replacement is sold, the benefit is larger.
The formulas
The paper loss the sale realises.
Gains first, then income, each at its own rate.
What is left for future years.
While losses offset gains, each dollar saves the capital-gains rate.
The return on the tax before it is paid back.
Worked example
The loss first. Then apply it in order: against gains at the capital-gains rate, against $3,000 of income at the income rate, and carry the rest forward.
See it move
Same client and the same position. Change what was paid, how far it has fallen, the gains realized elsewhere this year, the two tax rates, the return on the tax saved and the years until the replacement is sold.
- Raise the gains realized this year and watch the tax saved. It can fall: gains absorb loss that would otherwise have offset $3,000 of income at the higher rate, and a dollar of loss is worth more against income than against gains. Once the gains exceed the loss, nothing moves.
- Raise the fall in value. The loss and the tax saved rise, and so does the deferral benefit.
- Raise the capital-gains rate. Tax saved against gains rises, and so does the deferral benefit; the income slice does not move.
- Add years or raise the return on the tax saved. The net benefit of harvesting rises; the tax saved now does not move.
Run it backwards
The client wants this year's bill cut by a stated amount, and has gains to set it against. How large a loss must be harvested?
While losses are offsetting gains, each dollar of loss saves the capital-gains rate, so the loss needed is the saving over that rate. The check is that it fits inside the gains available.
Beyond the gains, the next $3,000 saves at the income rate and the rest saves nothing this year, so a larger target may not be reachable in one year.
Traps
Say it in the interview
“Should this client harvest the loss, and what is it worth?”
Check yourself
4 fresh questions, with new numbers. Answer each one correctly to finish the chapter. Get one wrong and you will see the full working, then you can try it again with new numbers.
Answers within 1% are marked right. Type the number; $, %, x and M are fine. First tries count toward Learned: the topic is Learned once every chapter is done and 75% of first tries were right.
- Gains first, then $3,000 of income, then carry forward; each slice at its own rate.
- Loss needed to save X against gains = X ÷ capital-gains rate.
- The benefit is the deferral, plus any rate difference later.
- No substantially identical purchase within 30 days, in any household account.