How does tax loss harvesting work and what are the rules?

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AcadiFi · Accepted Answer

Tax loss harvesting (TLH) is the practice of selling positions at a loss to realize deductible capital losses while maintaining portfolio exposure...

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Mechanics: (1) identify a position with unrealized loss; (2) sell it to realize the loss; (3) immediately purchase a similar-but-not-identical replacement to maintain exposure; (4) after the 30-day wash sale window, optionally sell replacement and repurchase original (though many investors simply hold the replacement).

Example: Kenzo Ishida owns 2,000 shares of a large-cap technology ETF bought at $180, currently at $145, showing $70,000 unrealized loss. He sells the ETF, immediately buys a different large-cap tech ETF from another provider tracking a slightly different index. He realizes $70,000 loss, uses it to offset $70,000 of existing long-term gains — at 23.8% rate, saving $16,660 in tax. His market exposure is essentially unchanged.

Key rules: (1) wash sale rule — cannot repurchase the same or 'substantially identical' security within 30 days before or after the sale, else loss is disallowed; (2) loss use hierarchy — losses first offset same-category gains, then cross-category gains, then up to $3,000 offsets ordinary income, remainder carries forward; (3) step-up at death — if you die holding the position, basis resets and loss harvesting opportunity is lost.

```mermaid
flowchart LR
  A[Identify Loss] --> B[Sell Position]
  B --> C[Buy Replacement]
  C --> D[30-Day Window]
  D --> E[Loss Realized]
  E --> F[Offset Gains]
```

Quantifying the benefit: academic research (Berkin-Ye, Chaudhuri-Burnham-Lo) estimates TLH adds 0.5-1.5% annually in after-tax return for high-bracket investors, depending on market volatility and turnover. Higher volatility and more bifurcated returns produce more harvesting opportunities. Systematic TLH at the individual-security level (available through direct indexing) can exceed 2% annually.

Constraints: (1) eventual basis reduction — every harvested loss reduces future basis, so TLH defers rather than eliminates tax unless combined with step-up at death or charitable giving; (2) transaction costs — minimize by using no-transaction-fee ETFs; (3) tracking-error risk — replacement security must have low correlation difference with original. For CFA Level III, model TLH benefit as the present value of tax savings net of future basis reduction, recognizing the long-term tax deferral value.

How does tax loss harvesting work and what are the rules?

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