A Complete Guide to Tax-Loss Harvesting With ETFs

Nobody likes losing money on an investment. But what if the loss was only temporary, on paper, and could lower your tax bill? Then you’d be doing tax-loss harvesting, a common practice among investors looking to reduce their taxes.

Tax-loss harvesting is the selling of assets for a loss with the intention of using that loss to offset capital gains or regular income reported to the IRS. The trick is that any new investment you make after selling for the tax loss can’t be “substantially identical” to the old one. That’s where exchange-traded funds (ETFs) can be useful. They’re easy and inexpensive to trade, and there are many different ones, often just different enough to help investors harvest a tax loss while avoiding trouble with the IRS.

Understanding Tax-Loss Harvesting

Tax-loss harvesting is selling an investment at a loss to offset capital gains elsewhere in your portfolio. The crucial element that makes this a sound strategy rather than simply locking in losses or trying to time the market is what you do with the proceeds: you would reinvest them in similar (but not identical) assets that fulfill the same role in your portfolio. This keeps you fully invested in that part of the market while still capturing the tax benefit, which can improve your after-tax returns over time.

Let’s look at the steps involved:

• Realized capital gain: Let’s say you have $10,000 in profit on a short-term investment (held fewer than 12 months) and want to offset some of the tax liability.
• Sell another investment at a loss: Even though you believe this other investment (for the sake of illustration, also held fewer than 12 months) will be profitable eventually, its value is $2,000 below the price you paid. You sell it for $20,000 and take the capital loss.
• Reinvest in a different but similar asset: You find a similar asset, perhaps in the same industry or sector, to reinvest the $20,000.
• Use the loss to offset the tax liability: When you file your taxes, you deduct the $2,000 loss from the $10,000 profit, leaving a taxable capital gain of $8,000. Let’s say you face a short-term capital gains tax rate of 22%—in that case, you’ve cut $440 off your tax liability for the $10,000 profit, reducing it from $2,200 to $1,760.

The Wash Sale Rule

Successful tax-loss harvesting requires adhering to the IRS’s wash sale rule: you can’t claim a capital loss if you buy a “substantially identical” security either 30 days before or after selling the other at a loss. The rule is meant to prevent investors from claiming artificial losses while maintaining the same investment exposure.

Obviously, that means investors can’t buy back the same security they sold for a loss. But what does “substantially identical” mean, exactly? The IRS doesn’t define what’s meant in great detail, but investors should assume that they know it when they see it. If the IRS decides the new investment is substantially identical, it will disallow the capital loss and require you to add the dollar amount of the loss to the cost basis of the new investment.

Using the example above, if the $2,000 loss was disallowed, when it came time to report any profit on the $20,000 investment that was deemed “substantially identical,” you’d have to report the cost basis—what you paid for it—as $22,000.

Investors should consult a tax professional before engaging in tax-loss harvesting. That said, the basic approach to adhering to the wash sale rule, particularly with ETFs, is to carefully consider the degree to which the underlying assets of the two vehicles overlap and the difference in their prospective returns.

Harvesting Losses With ETFs

ETFs are a popular investment vehicles for tax-loss harvesting. Here are some of the reasons:

Diversification: Investors can access a wide range of markets and asset types via ETFs, including stock indexes, sectors, bond indexes, or specialized themes. If you sell a commodity-focused ETF at a loss, it is easy to invest in another with a somewhat different focus, but that isn’t substantially identical. You might sell one that tracks the price of gold and buy another that comprises gold producers. But exchanging one ETF that tracks the S&P 500 index for another that does the same is very unlikely to be allowed.

Ease of trading: Unlike mutual funds, ETFs can be easily bought and sold throughout the trading day. In fact, you could sell one ETF and buy another in the same trading session to seamlessly maintain exposure.

Other Tax-Loss Harvesting Considerations

Investors approach tax-loss harvesting differently. In fact, some may not be entirely comfortable with it. Here are two very different alternatives for tax-loss harvesting strategies:

An “always on” approach: Some advisers recommend investors look for opportunities to harvest losses throughout the year, not just as the end of the year approaches. They argue that this offers more opportunities. For example, JPMorgan Asset Management argues that investors holding individual stocks should look for such opportunities daily, taking advantage of natural volatility in the market, with its analysis finding that it resulted in 30 basis points of annualized tax savings.

However, this approach raises several practical concerns to watch out for in any tax-loss harvest strategy, but particularly when done so frequently: the transaction costs from frequent trading could easily outweigh the tax benefits; constantly monitoring and executing trades would be highly time-consuming for individual investors without automated systems; and carefully tracking multiple securities to avoid wash sale violations becomes significantly more complex with daily trading.

Comfort level: Not everyone is comfortable moving quickly in and out of the markets, taking a loss on an investment they believe will ultimately be profitable while operating in a gray area regarding taxes and the IRS. Investors should fully understand and be fully comfortable with the benefits and drawbacks of tax-loss harvesting.

Many financial advisors recommend a moderate approach, such as quarterly reviews or harvesting during significant market downturns.

Further Tax Implications

Here are some other things to know about the implications of tax-loss harvesting for your tax bill:

Short-term vs. long-term: For tax purposes, gains and losses are categorized as short- or long-term, depending on whether you held the investment for more than a year. Short-term losses will always offset short-term gains first, which can be useful because short-term gains are generally taxed at a higher rate than long-term gains.

Application to ordinary income: While a capital loss must first be applied to any capital gains, if you lack capital gains for a given year, or if your capital losses exceed your capital gains, you can apply some of the loss to regular income. Married couples filing jointly, for example, can use up to $3,000 a year, and any leftover losses can be carried over to the following year.

Future taxes: When you sell one investment at a loss and buy a similar one, your cost basis resets at a lower level, meaning you paid less for the second investment. That exposes you to a bigger capital gain (and a bigger tax bill) if and when you sell that second investment for a profit. But many investors prefer to take the tax break while it’s available, often for specific purposes such as offsetting a particular gain or dodging a higher tax bracket.

The Bottom Line

Tax-loss harvesting can be a smart way to lower your tax bill. By selling investments that have dropped in value and reinvesting in similar—but not identical—assets, you can lower your tax bill while still staying invested.

ETFs make this easier and cheaper due to their variety, ease of trading, and relatively low costs.