Tax-Loss Harvesting: How to Turn Market Crashes into Tax Refunds
Tax-Loss Harvesting: How to Turn Market Crashes into Tax Refunds
EXECUTIVE SUMMARY
- The Mechanism: When an investment drops in value, you sell it to “realize” the loss for tax purposes. You immediately use the cash to buy a highly correlated (but not “substantially identical”) asset to maintain your market exposure.
- The Benefit: The realized losses can offset unlimited Capital Gains and up to $3,000 of Ordinary Income (W-2 salary) per year. Unused losses carry forward forever.
- Authority Baseline: This analysis adheres to the Wash Sale Rule (IRC ยง 1091), ensuring the replacement asset is sufficiently different to preserve the tax deduction.
- Scope Limitation: This applies only to Taxable Brokerage Accounts. You cannot harvest losses in an IRA or 401(k).
Most investors treat losses as failures. Smart investors treat losses as assets. Tax-Loss Harvesting (TLH) is the only way to squeeze juice out of a lemon. By systematically banking losses during volatility, you build a “Tax Asset” (Carryforward Loss) that shields your future profits from the IRS. According to Team BMT Analysis, consistent TLH adds roughly 0.5% to 1.0% to your annual after-tax returns. Source: Wealthfront / Betterment Whitepaper
Scenario: You own Vanguard S&P 500 (VOO). It is down $5,000.
- Action 1 (Sell): Sell VOO. Book a $5,000 Capital Loss.
Impact: You now have a $5,000 tax deduction coupon. - Action 2 (Buy): Immediately buy Vanguard Total Stock Market (VTI).
Logic: VTI is 80% S&P 500, so it moves almost identically. But it tracks a different index (CRSP vs S&P), so it avoids the Wash Sale rule. - Result: You are still invested in the market recovery, but you “harvested” a $5,000 write-off.
Tax Savings Potential
| Action | Net Wealth Impact (Assuming 30% Tax Rate) |
|---|---|
| Hold (Do Nothing) | 0 |
| Harvest $10k Loss | 3000 |
*Chart Note: Harvesting a $10,000 loss generates $3,000 in actual cash savings (tax reduction) if used to offset short-term gains or ordinary income.
CRITICAL SCENARIO: The “Wash Sale” Trap
Don’t buy it back too soon.
| Mistake | Consequence |
|---|---|
| Selling VOO and buying VOO within 30 days | Wash Sale. The loss is disallowed and added to the new basis. No tax benefit. |
| Selling VOO in Taxable and buying VOO in IRA | Wash Sale. The IRS looks at all your accounts. This destroys the loss permanently. |
Execution Protocol
Pre-select your pairs.
US Stocks: VOO (S&P 500) <-> VTI (Total Market).
Int’l Stocks: VEA (Developed) <-> IEFA (Core EAFE).
Emerging: VWO (Emerging) <-> IEMG (Core Emerging).
Don’t harvest for $50. It’s not worth the paperwork. Set a threshold (e.g., losses > $3,000) to ensure the tax savings outweigh the bid-ask spread and effort.
If you have $50,000 in losses but no gains this year, deduct $3,000 from your salary and carry forward $47,000 to next year. This is a “Tax Shield” that protects future profits.
Decision Order: Check Holding Period (Short/Long) โ Confirm No Wash Sale โ Execute Swap โ Record Loss.
WEALTH STRATEGY DIRECTIVE
- Do This: Aggressively harvest losses in the first 5 years of your investing journey. This builds a “Loss Bank” that can offset gains when you rebalance later in life.
- Avoid This: Harvesting losses on assets you plan to donate to charity. It’s better to donate appreciated assets (to avoid tax) than to sell them at a loss.
Frequently Asked Questions
Is VOO and IVV a Wash Sale?
Likely yes. They track the exact same index (S&P 500). To be safe, switch indices (e.g., S&P 500 to Total Market or Large Cap 1000).
Can I buy back the original?
Yes, after 31 days. Once the Wash Sale window closes, you can swap VTI back to VOO if you prefer the original holding.
Does this lower my basis?
Yes. By realizing a loss, your new asset has a lower cost basis. This means higher taxes in the future (tax deferral). But keeping money now is worth more than paying it later (Time Value of Money).