Tax Loss Harvesting
Tax Loss Harvesting
A tax strategy of selling securities at a loss to offset capital gains and reduce tax liability. Realized losses can offset capital gains dollar-for-dollar, with up to $3,000 of excess losses deductible against ordinary income annually. Subject to the wash sale rule, which prohibits repurchasing substantially identical securities within 30 days before or after the sale.
An investor holds Stock A with a $10,000 unrealized loss and Stock B with a $15,000 unrealized gain. By selling Stock A before year-end, the investor can offset the $10,000 loss against the $15,000 gain, reducing taxable capital gains to $5,000. The investor must wait 31 days before repurchasing Stock A to avoid a wash sale violation.
Students often forget the wash sale window is 30 days BEFORE and 30 days AFTER the sale (61-day total window), not just 30 days after. They also confuse thinking all losses can offset ordinary income equally when only $3,000 of excess losses per year can offset ordinary income, and losses must first offset capital gains.
How This Is Tested
- Identifying wash sale violations when securities are repurchased within the 30-day window before or after the sale
- Calculating net capital gains or losses after applying tax loss harvesting to a portfolio
- Understanding the $3,000 annual limit for deducting excess capital losses against ordinary income
- Determining whether a replacement security is "substantially identical" for wash sale purposes
- Understanding how harvested losses can be carried forward to future tax years
Regulatory Limits
| Description | Limit | Notes |
|---|---|---|
| Wash sale window (before sale) | 30 days before | Cannot repurchase substantially identical security 30 days before the sale date |
| Wash sale window (after sale) | 30 days after | Cannot repurchase substantially identical security 30 days after the sale date |
| Total wash sale window | 61-day period | 30 days before + day of sale + 30 days after |
| Ordinary income deduction limit | $3,000 annually | Maximum excess capital loss deductible against ordinary income per year ($1,500 if married filing separately) |
| Capital loss carryforward | Unlimited years | Excess losses beyond $3,000 annual limit can be carried forward indefinitely to future tax years |
Example Exam Questions
Test your understanding with these practice questions. Select an answer to see the explanation.
Marcus, a tax-conscious investor, has realized capital gains of $25,000 this year from selling Stock A. He also holds Stock B, currently showing an unrealized loss of $18,000. On December 15, Marcus sells Stock B to harvest the loss. On January 10 of the following year, Marcus repurchases Stock B because he believes it will recover. What is the tax consequence of this transaction?
B is correct. Marcus violated the wash sale rule by repurchasing Stock B within 30 days after the sale (December 15 to January 10 is 26 days). The wash sale rule prohibits repurchasing substantially identical securities within 30 days before OR after the sale. When a wash sale occurs, the loss is disallowed for current tax purposes, and the disallowed loss is added to the cost basis of the repurchased security.
A is incorrect because the wash sale violation disallows the loss entirely. Marcus cannot use the $18,000 loss to offset his $25,000 capital gain in the current year. C is incorrect because it describes the $3,000 ordinary income deduction limit, which only applies to excess capital losses AFTER offsetting capital gains. Here, the loss is completely disallowed due to the wash sale. D is incorrect because the wash sale rule is not based on calendar years but on the 61-day window (30 days before and 30 days after the sale date). Simply waiting until the next year does not avoid the violation if the repurchase occurs within 30 days.
The Series 65 exam frequently tests wash sale rule violations in tax loss harvesting scenarios. Understanding that the 30-day window applies both before and after the sale date is critical. Advisers must help clients avoid wash sale violations when implementing tax loss harvesting strategies, as violations negate the intended tax benefit.
Under IRS regulations, what is the maximum amount of excess capital losses (after offsetting all capital gains) that an individual taxpayer can deduct against ordinary income in a single tax year?
B is correct. Individual taxpayers can deduct up to $3,000 of excess capital losses against ordinary income in a single tax year ($1,500 if married filing separately). This limit applies only to losses that exceed capital gains. Losses must first offset capital gains dollar-for-dollar, and only the remaining excess losses are subject to this $3,000 annual limitation.
A ($1,500) is the limit for married taxpayers filing separately, not the standard individual limit. C ($10,000) is not a recognized IRS limit for capital loss deductions. D is incorrect because there is a strict annual limit; taxpayers cannot deduct unlimited excess capital losses against ordinary income. However, excess losses beyond the $3,000 annual limit can be carried forward indefinitely to future tax years.
The Series 65 exam tests knowledge of the $3,000 annual ordinary income deduction limit as a key component of tax loss harvesting strategy. This limit affects how advisers structure year-end tax planning for clients with substantial capital losses, and understanding the carryforward provision is essential for multi-year tax planning.
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Access Free BetaAn investor has the following transactions in the current tax year: $40,000 in realized short-term capital gains, $15,000 in realized long-term capital gains, $22,000 in realized short-term capital losses (from tax loss harvesting), and $8,000 in realized long-term capital losses (from tax loss harvesting). What is the investor's net capital gain or loss for the year, and how much (if any) can be deducted against ordinary income?
A is correct. Calculate by netting short-term and long-term separately, then combining:
Short-term: $40,000 gains - $22,000 losses = $18,000 net short-term gain
Long-term: $15,000 gains - $8,000 losses = $7,000 net long-term gain
Total net capital gain: $18,000 + $7,000 = $25,000
Since the investor has a net capital GAIN (not a loss), there are no excess losses to deduct against ordinary income. The entire $25,000 net capital gain is taxable as capital gains (with short-term gains taxed at ordinary income rates and long-term gains at preferential capital gains rates).
B is incorrect because it incorrectly calculates a net loss when the investor actually has substantial net gains. C ($7,000) only accounts for the long-term calculation and ignores the $18,000 short-term net gain. D incorrectly shows a net loss, which is mathematically wrong given the numbers provided.
The Series 65 exam tests the ability to calculate net capital gains and losses when tax loss harvesting is employed. Understanding that losses must first offset gains before any excess can be applied to the $3,000 ordinary income deduction is essential. This calculation skill is critical for advising clients on year-end tax planning strategies.
All of the following statements about tax loss harvesting are accurate EXCEPT
C is correct (the EXCEPT answer). The wash sale rule applies to purchases made within 30 days BEFORE and 30 days AFTER the sale, creating a 61-day window (30 days before + day of sale + 30 days after). Many investors and students incorrectly think the rule only looks forward 30 days after the sale, but the IRS also examines purchases made in the 30 days before the loss sale.
A is accurate: Realized capital losses offset capital gains on a dollar-for-dollar basis without limitation, making tax loss harvesting an effective strategy for reducing capital gains tax liability. B is accurate: Excess capital losses that cannot be used in the current year (beyond offsetting all gains and the $3,000 ordinary income deduction) can be carried forward indefinitely to offset gains in future tax years. D is accurate: Both short-term capital losses (from securities held one year or less) and long-term capital losses (from securities held more than one year) can be harvested and used to offset their respective types of gains, or offset gains of the other type if needed.
The Series 65 exam tests detailed knowledge of the wash sale rule, particularly the often-overlooked "30 days before" component. This is a common trap question because many candidates only remember the "30 days after" portion. Understanding the full 61-day window is critical for properly advising clients on timing their tax loss harvesting and replacement purchases.
A client realizes a $50,000 capital gain from selling Stock A and wants to harvest losses before year-end to reduce tax liability. The client is considering selling securities currently showing unrealized losses. Which of the following considerations are accurate regarding the tax loss harvesting strategy?
1. The client should harvest at least $50,000 in losses to completely eliminate the capital gains tax liability
2. If the client harvests $60,000 in losses, the excess $10,000 can be deducted entirely against ordinary income this year
3. The client must wait 31 days after selling a security before repurchasing it to avoid a wash sale violation
4. If a wash sale occurs, the disallowed loss is permanently lost and cannot be recovered
A is correct. Statements 1 and 3 are accurate.
Statement 1 is TRUE: Harvesting $50,000 in losses would fully offset the $50,000 capital gain on a dollar-for-dollar basis, eliminating capital gains tax liability on that gain for the current year.
Statement 2 is FALSE: If the client harvests $60,000 in losses against $50,000 in gains, there is a $10,000 excess loss. However, only $3,000 of that excess can be deducted against ordinary income in the current tax year. The remaining $7,000 ($10,000 - $3,000) must be carried forward to future tax years.
Statement 3 is TRUE: To avoid a wash sale violation, the client must wait at least 31 days after the sale before repurchasing the same or substantially identical security. The wash sale rule prohibits repurchases within 30 days after the sale, so waiting 31 days clears the window.
Statement 4 is FALSE: When a wash sale occurs, the disallowed loss is not permanently lost. Instead, it is added to the cost basis of the repurchased security, effectively deferring the loss recognition until the replacement security is eventually sold. This preserves the economic value of the loss but delays the tax benefit.
The Series 65 exam tests comprehensive understanding of tax loss harvesting mechanics, including the $3,000 ordinary income deduction limit, wash sale timing rules, and the treatment of disallowed losses. Understanding that wash sale losses are deferred (not lost) and that excess losses beyond $3,000 must be carried forward is essential for providing accurate tax planning advice to clients.
💡 Memory Aid
Think of tax loss harvesting as "Selling Lemons to Sweeten the Tax Bill": You sell your losing positions (lemons) to offset winning positions, making your tax bill less bitter. But remember the "61-Day No-Buyback Zone": 30 days before + sale day + 30 days after. If you rebuy too soon, it's a wash sale and the lemon is spoiled (loss disallowed). The IRS gives you $3,000 of sympathy annually to offset ordinary income for excess losses.
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