Tax-Loss Harvesting Done Right: The Wash Sale Rule and Other Details That Matter
Updated: Sep 27
Realizing losses to offset gains is one of the few tax strategies available every year. The rules around it are simple to state and easy to get wrong.
Tax-loss harvesting means selling an investment that has declined in value to realize a capital loss, then using that loss to offset capital gains and, to a limited extent, ordinary income. For Silicon Valley investors who regularly realize gains from selling employer stock, harvested losses can meaningfully reduce the tax cost of diversification. The strategy is not complicated, but its value depends on executing it correctly. This article is not intended to provide tax advice, and you should consult with a tax professional regarding your situation.
How losses are used
Capital losses first offset capital gains of the same character: short-term losses against short-term gains, long-term against long-term. Net losses of one type then offset net gains of the other. If losses still remain, up to $3,000 per year ($1,500 if married filing separately) can be deducted against ordinary income, and any excess carries forward indefinitely. IRS Topic 409 describes these rules.
The economic benefit of harvesting is often a deferral rather than a permanent saving. Selling at a loss and buying a replacement resets your cost basis lower, so a future sale of the replacement will produce a larger gain. The benefit comes from the time value of the deferred tax, from the possibility of realizing that future gain at a lower rate, from offsetting short-term gains taxed at ordinary rates, and from the potential to eliminate the gain entirely through a charitable gift or a step-up in basis at death.
The wash sale rule
The wash sale rule is the principal constraint. As Charles Schwab's primer explains, a loss is disallowed if you buy a substantially identical security within 30 days before or after the sale, a 61-day window in total. The disallowed loss is not lost; it is added to the basis of the replacement shares, and the holding period of the original shares carries over.
Several features of the rule catch investors by surprise:
It applies across all of your accounts, including IRAs and accounts at other custodians, and extends to a spouse's accounts. Buying the same fund in your IRA that you just sold at a loss in a taxable account triggers the rule, and a loss disallowed because of an IRA purchase is permanently lost.
Automatic purchases count. Dividend reinvestment, automatic 401(k) contributions into the same fund, and RSU vesting can all create wash sales.
Employer stock is a common trap. If you sell company shares at a loss and then a new RSU tranche vests within 30 days, the vesting is treated as a purchase and the loss on the matching number of shares is disallowed.
"Substantially identical" is not precisely defined. Two funds tracking the same index from different sponsors are generally regarded by practitioners as not substantially identical, while shares of the same company, or an option on that stock, clearly are. This is an area of judgment.
Direct indexing
Owning individual stocks that replicate an index, rather than a single index fund, creates many more opportunities to harvest losses at the position level even in years when the overall market rises. This approach, often called direct indexing, has become more accessible as trading costs have fallen. It works best for investors with ongoing gains to offset, such as those diversifying out of concentrated employer stock, and it requires disciplined tracking of lots and wash sale windows.
California considerations
California generally conforms to federal capital loss rules, including the $3,000 annual limit and the carryforward. Because California taxes all capital gains as ordinary income at rates up to 13.3%, per NerdWallet's summary of California rates, the state-level value of a harvested loss is often as significant as the federal value.
Practical habits
Review taxable accounts for losses periodically, not just in December. Market declines that create harvesting opportunities can occur at any time of year and may reverse quickly.
Keep a calendar of RSU vesting dates and ESPP purchase dates to avoid inadvertent wash sales when selling employer stock at a loss.
Use specific lot identification when selling so that you control which shares are sold.
Reconcile your broker's Form 1099-B, which reports wash sales only within the same account, with activity across all accounts.
Tax-loss harvesting is a useful tool, but the tax tail should not wag the investment dog. The replacement security should be one you would be comfortable owning on its merits. This article is educational only and is not tax or investment advice; consult a qualified professional regarding your circumstances.
Important Disclosures
Important Disclosures: Propulsion Capital Management is an investment adviser registered with the State of California Department of Financial Protection and Innovation. Registration does not imply a certain level of skill or training. This article is provided for general informational and educational purposes only and does not constitute investment, tax, legal, or accounting advice, nor an offer or solicitation to buy or sell any security or to adopt any particular investment strategy. The information is believed to be accurate as of the date of publication but is subject to change without notice; tax laws and regulations change frequently and their application depends on individual facts and circumstances. Nothing herein should be relied upon as a substitute for personalized advice from a qualified professional. Investing involves risk, including the possible loss of principal, and past performance is no guarantee of future results. Diversification does not ensure a profit or protect against loss. Any examples are hypothetical, are for illustrative purposes only, and do not reflect the experience of any client. Links to third-party websites are provided for convenience; Propulsion Capital Management does not endorse, and is not responsible for, the content of third-party sites. Propulsion Capital Management does not provide tax or legal advice; please consult your tax adviser or attorney regarding your specific situation.
