Tax-Loss Harvesting

Purpose

Execute a complete tax-loss harvesting (TLH) workflow from candidate identification through post-harvest monitoring. Provides decision criteria, quantitative thresholds, replacement security selection logic, wash-sale compliance tracking across accounts, and household-level coordination that go beyond the overview in the tax-efficiency skill.

Layer

5 — Policy and Planning

Direction

both

When to Use

• Scanning a portfolio for unrealized losses that exceed a materiality threshold
• Building a gain/loss budget for the current tax year to determine target harvest amount
• Selecting replacement securities that maintain factor exposure without triggering wash-sale rules
• Tracking the 61-day wash-sale window across taxable, IRA, and spouse accounts
• Generating a TLH trade list coordinated with rebalancing
• Calculating the after-tax value of a proposed harvest including state taxes and NIIT
• Monitoring replacement positions and planning swap-back timing after the wash-sale window closes
• Preparing TLH opportunity summaries for client reviews

Core Concepts

Candidate Identification

Scan the portfolio for positions with unrealized losses that meet all three filters:

• Materiality threshold: Minimum absolute loss (e.g., $2,000) or minimum loss-to-value ratio (e.g., loss exceeds 5% of position market value). Harvesting a $200 loss on a $50,000 portfolio is not worth the operational cost.
• Holding period filter: Positions held less than 31 days may not have meaningful losses and create short-term wash-sale complexity. Positions approaching the one-year mark (days 335-365) may benefit from waiting to convert a short-term loss into a long-term loss only if the position is expected to continue declining.
• Loss magnitude ranking: Rank candidates by Tax Benefit = Unrealized Loss * Applicable Tax Rate. Prioritize short-term losses (taxed at ordinary rates up to 37%) over long-term losses (taxed at capital gains rates of 15-20%) when gain/loss budget allows.

Gain/Loss Budgeting

Before harvesting, build the year-to-date tax budget:

1. Realized gains YTD: Sum all short-term and long-term capital gains already realized (including fund distributions).
2. Planned gain exposure: Estimate gains from pending rebalancing trades, planned liquidations, or expected fund capital gain distributions.
3. Loss carryforward balance: Check prior-year unused capital loss carryforwards (these offset gains before new harvests do).
4. Target harvest amount: Target Harvest = (Realized Gains YTD + Planned Gains) - Loss Carryforward - $3,000 ordinary income offset. Harvest at least this amount to zero out the current-year tax bill; harvest more to build carryforward for future years.

Replacement Security Selection

The replacement must maintain market exposure without being "substantially identical":

• ETF-to-ETF swaps: Switch between funds tracking different indices (e.g., Vanguard Total Stock Market to Schwab Broad Market, or S&P 500 to Russell 1000). Different index methodology is generally sufficient.
• Individual stock replacement: Replace a single stock with a sector ETF or a peer company. Example: sell Apple, buy Technology Select Sector SPDR (XLK).
• Tracking error budget: The replacement should have a correlation of 0.95+ and tracking error under 2% annualized relative to the original holding. Wider tracking error is acceptable for larger tax benefits.
• Expense ratio delta: Ensure the replacement does not have meaningfully higher expenses. A 10 bps cost increase on a $100K position held for 30 days costs roughly $8 — negligible against a $2,000+ tax benefit.

Wash-Sale Compliance

The wash-sale rule (IRC Section 1091) disallows a loss if a substantially identical security is acquired within the 61-day window (30 days before + sale date + 30 days after):

• Cross-account scope: The rule applies across ALL accounts owned by the taxpayer: taxable brokerage, Traditional IRA, Roth IRA, 401(k), HSA, and spouse's accounts. A purchase in any of these accounts triggers wash-sale disallowance.
• IRA wash-sale trap: If a wash sale is triggered by a purchase in an IRA, the disallowed loss is permanently lost — it cannot be added to the IRA cost basis. This is the most dangerous wash-sale scenario.
• DRIP suspension: Automatic dividend reinvestment (DRIP) in the sold security or a substantially identical fund must be suspended during the 61-day window. Reinvesting even a small dividend triggers a partial wash sale.
• Spouse coordination: Purchases in a spouse's accounts (including retirement accounts) trigger wash-sale rules. Both spouses' automatic investments, 401(k) contributions, and DRIP settings must be reviewed.

Execution Planning

Translate candidates into an actionable trade list:

• Lot selection method: Use Specific Identification (Spec ID) to select the highest-cost-basis lots first (HIFO). This maximizes the realized loss per share sold. If only partial harvesting is needed, sell only the lots with cost basis above current market price.
• Coordination with rebalancing: If the portfolio also needs rebalancing, combine TLH sells with rebalance sells to reduce total trade count. A position that is both overweight and at a loss is the ideal candidate — the harvest and rebalance are the same trade.
• Timing strategy: Year-end harvesting (October-December) captures the full year's losses but faces market timing risk. Opportunistic harvesting throughout the year during drawdowns of 5%+ captures losses that may recover by year-end.
• Trade list fields: Security, account, action (sell/buy), shares, lot IDs, estimated loss, replacement security, wash-sale window start/end dates.

Tax Savings Calculation

Quantify the dollar value of each proposed harvest:

• Federal rate selection: Short-term losses offset short-term gains first (up to 37% ordinary rate). Long-term losses offset long-term gains (15-20% rate). Net losses of either type can cross over to offset the other, then up to $3,000 offsets ordinary income.
• State tax impact: Most states tax capital gains as ordinary income (rates 0-13.3%). Include state tax savings in the calculation; for a California resident at the 13.3% bracket, state tax roughly doubles the benefit of each harvest.
• NIIT interaction: The 3.8% Net Investment Income Tax (IRC Section 1411) applies to the lesser of net investment income or MAGI exceeding $250,000 (MFJ). Harvested losses reduce net investment income, potentially eliminating NIIT exposure.

Post-Harvest Monitoring

After executing the harvest:

• Wash-sale window tracking: Maintain a calendar of open wash-sale windows with security identifiers and expiration dates. Flag any pending purchases (including automated ones) that would violate the window.
• Replacement performance: Monitor tracking error between the replacement and original security. If the replacement significantly underperforms (>3% divergence), evaluate whether the tax benefit justified the swap.
• Cost basis updates: Verify that broker statements reflect the new (lower) cost basis on replacement securities. The replacement's basis equals purchase price, not the original security's basis.
• Swap-back timing: After the 31st day, the investor may sell the replacement and repurchase the original security if desired. Evaluate whether the swap-back itself triggers a taxable gain on the replacement position.

Household-Level Coordination

TLH across a household with multiple accounts requires centralized tracking:

• Account type matrix: Taxable accounts are the only accounts where TLH generates direct tax benefits. Retirement accounts have no realized gains/losses for tax purposes, but they can trigger wash sales in taxable accounts.
• Advisor-managed vs held-away: If the client has accounts at other institutions (401(k) plan, outside brokerage), the advisor cannot control purchases. Document held-away holdings and instruct the client to avoid purchasing substantially identical securities during open wash-sale windows.
• Spousal coordination checklist: (1) Review spouse's 401(k) fund lineup for overlap, (2) suspend DRIP in spouse's accounts for harvested securities, (3) coordinate any year-end tax trades across both spouses.

Key Formulas

Formula	Expression	Use Case
Tax Benefit	Benefit = Realized_Loss * Applicable_Tax_Rate	Dollar value of a single harvest
Net Tax Alpha	Alpha = Tax_Savings - Tracking_Error_Cost - Transaction_Costs	True value after implementation costs
Break-Even Holding Period	T_be = Tax_Savings / (Annual_Tracking_Error_Cost + Annual_Expense_Delta)	How long replacement can be held before costs exceed benefit
Wash-Sale Adjusted Basis	New_Basis = Replacement_Purchase_Price + Disallowed_Loss	Cost basis when wash sale is triggered
Annual TLH Capacity	Capacity = Portfolio_Value * Expected_Volatility * Loss_Capture_Rate	Estimate of harvestable losses per year
Target Harvest Amount	Target = Realized_Gains_YTD + Planned_Gains - Loss_Carryforward - 3000	Minimum harvest to zero out current-year tax

Worked Examples

Example 1: Single Position Harvest with Replacement Selection

Given:

• Client holds 500 shares of XYZ Corp purchased at $80/share ($40,000 cost basis), current price $62/share ($31,000 market value), held 8 months (short-term)
• Client has $12,000 in short-term realized gains YTD, marginal federal rate 35%, state rate 9.3%, NIIT applies (3.8%)
• Replacement candidate: Sector ETF (correlation 0.97, tracking error 1.4% annualized, expense ratio 0.10% vs 0% for individual stock)

Calculate: Tax benefit, net tax alpha, and break-even holding period for the replacement.

Solution:

1. Unrealized loss: $31,000 - $40,000 = -$9,000 (short-term)
2. Applicable rate: 35% federal + 9.3% state + 3.8% NIIT = 48.1% combined
3. Tax benefit: $9,000 * 48.1% = $4,329
4. Transaction costs: Commission $0 (zero-commission broker) + estimated spread cost 0.05% * $31,000 * 2 trades = $31
5. Tracking error cost: 1.4% annualized * $31,000 * (30/365) = $36 (for the 30-day minimum hold)
6. Net tax alpha: $4,329 - $31 - $36 = $4,262
7. Annual cost of replacement: $31,000 * (0.10% expense + 1.4% tracking error drag estimate of 0.05%) = $46.50/year
8. Break-even holding period: $4,262 / $46.50 = 91.7 years — the tax benefit overwhelmingly justifies the swap
9. Action: Sell XYZ Corp (Spec ID, all lots), buy Sector ETF. Set wash-sale window reminder for 31 calendar days. Suspend any XYZ DRIP in all household accounts.

Example 2: Portfolio-Wide TLH Scan with Gain/Loss Budget

Given:

• $2M taxable portfolio, 15 equity positions, year is mid-October
• Realized gains YTD: $18,000 long-term, $5,000 short-term
• Loss carryforward from prior years: $0
• Planned rebalancing trades will realize approximately $4,000 in additional long-term gains
• Three positions show unrealized losses: Position A (-$14,000 LT), Position B (-$6,500 ST), Position C (-$2,100 LT)
• Federal LTCG rate 20%, ordinary rate 37%, state 5%, NIIT 3.8%

Calculate: Target harvest amount, prioritized trade list, and total tax savings.

Solution:

1. Gain/loss budget:
   • Total expected gains: $18,000 LT + $5,000 ST + $4,000 LT (planned) = $22,000 LT + $5,000 ST
   • Loss carryforward: $0
   • Target harvest: ($22,000 + $5,000) - $0 - $3,000 = $24,000 to fully offset gains and capture the $3,000 ordinary income deduction
2. Candidate ranking by tax benefit:
   • Position B: $6,500 ST * (37% + 5% + 3.8%) = $6,500 * 45.8% = $2,977 (highest rate — harvest first)
   • Position A: $14,000 LT * (20% + 5% + 3.8%) = $14,000 * 28.8% = $4,032 (largest absolute benefit)
   • Position C: $2,100 LT * 28.8% = $605
3. Harvest plan: Harvest all three: $14,000 + $6,500 + $2,100 = $22,600 in total losses
   • $5,000 ST losses offset $5,000 ST gains at 45.8% = $2,290 saved
   • $1,500 remaining ST losses cross over to offset LT gains at 28.8% = $432 saved
   • $16,100 LT losses offset $16,100 of $22,000 LT gains at 28.8% = $4,637 saved
   • Remaining $5,900 LT gains still taxable; $3,000 ordinary income offset not reached (all losses consumed by gains)
   • Total tax savings: $7,359
4. Coordinate with rebalancing: Position A is also 2% overweight — its TLH sell doubles as a rebalance sell, saving one round-trip trade.

Example 3: Wash-Sale Violation Across Accounts

Given:

• On November 5, client sells VTI (Vanguard Total Stock Market ETF) in taxable account for a $8,000 long-term loss
• On November 20 (15 days later), client's 401(k) makes its regular bi-weekly contribution, which includes an allocation to a Vanguard Total Stock Market Index Fund (institutional share class of the same fund)
• 401(k) contribution to the total stock market fund: $750

Calculate: Wash-sale impact and corrected cost basis.

Solution:

1. Wash-sale triggered: The 401(k) fund is substantially identical to VTI (same underlying index, same fund family). The purchase on November 20 falls within the 30-day post-sale window (November 5 + 30 = December 5).
2. Disallowed loss: The wash-sale disallowance is proportional to the replacement shares acquired. If 500 VTI shares were sold and the $750 401(k) purchase acquired the equivalent of approximately 3 shares at $250/share, then 3/500 = 0.6% of the loss is disallowed.
3. Disallowed amount: $8,000 * (3/500) = $48 disallowed
4. Remaining allowable loss: $8,000 - $48 = $7,952 — still deductible
5. Basis adjustment — 401(k) trap: The $48 disallowed loss would normally be added to the replacement security's cost basis. However, because the replacement was purchased inside a 401(k), the cost basis adjustment provides NO future tax benefit (401(k) distributions are taxed as ordinary income regardless of basis). The $48 is permanently lost.
6. Prevention: Before executing TLH, review the client's 401(k) fund lineup and contribution schedule. If the 401(k) holds a substantially identical fund, either (a) temporarily redirect that 401(k) allocation to a non-identical fund during the wash-sale window, or (b) delay the TLH sale until after the next 401(k) contribution and ensure no contribution occurs for 30 days after.

Common Pitfalls

• Harvesting losses without checking for substantially identical holdings in retirement accounts, triggering permanent loss disallowance in IRAs/401(k)s
• Forgetting to suspend DRIP on the sold security and related funds across all household accounts during the 61-day window
• Harvesting small losses (under $1,000) where transaction costs and operational complexity exceed the tax benefit
• Over-harvesting in early years, depressing cost basis so severely that future sales generate outsized gains (basis step-down compounding)
• Failing to coordinate with spouse's automated investments (401(k) payroll contributions, robo-advisor purchases)
• Selecting a replacement security that is substantially identical (same index, same fund family, different share class) — this does not avoid wash-sale rules
• Not tracking the holding period of replacement securities, leading to unintended short-term gains when the replacement is later sold
• Ignoring state tax differences when calculating harvest value — states with no income tax (FL, TX, NV) reduce the benefit by 5-13 percentage points versus high-tax states

Cross-References

• tax-efficiency (wealth-management plugin, Layer 5): broader tax-aware investing context; TLH is one strategy within the overall tax-efficiency framework
• rebalancing (wealth-management plugin, Layer 4): TLH trades should be coordinated with rebalancing to minimize total transaction count
• investment-suitability (compliance plugin, Layer 9): replacement securities must still satisfy suitability requirements
• investment-policy (wealth-management plugin, Layer 5): IPS may specify TLH policy parameters (minimum loss threshold, approved replacement pairs)
• performance-attribution (wealth-management plugin, Layer 5): tax alpha from TLH should be tracked and attributed separately
• client-review-prep (advisory-practice plugin, Layer 10): TLH opportunities are flagged during periodic client review preparation
• financial-planning-workflow (advisory-practice plugin, Layer 10): TLH is a specific tax recommendation that may emerge from the financial plan

Reference Implementation

See scripts/tax_loss_harvesting.py for computational helpers.