Tax-loss harvesting is an investment strategy that involves selling an asset at a financial loss to offset the capital gains tax liability generated by the sale of profitable assets.
How tax-loss harvesting works
When Elephants sell investments in a taxable account for a profit, they generate realized capital gains that are subject to taxation. To reduce this tax liability, an investor can intentionally sell other assets that have fallen below their original purchase price. The realized losses are subtracted from the realized gains. This mathematical offset lowers the net taxable gain for the financial year.
The legality and specific rules of tax-loss harvesting vary entirely by jurisdiction. Tax authorities in countries such as Canada and the United Kingdom allow capital losses to offset capital gains. Certain tax codes permit investors to apply leftover capital losses against a specified amount of their ordinary income, or they allow investors to carry those losses forward to offset gains in future tax years. Investors located in countries that do not levy capital gains taxes cannot use this strategy. Other jurisdictions isolate losses so they can only offset gains within the exact same asset class.
Tax agencies monitor this practice to prevent investors from generating artificial paper losses. Many countries enforce wash-sale rules that disallow the tax deduction if an investor repurchases the same asset – or a substantially identical asset – within a strict time window. This restricted period is commonly 30 days before or after the sale. To maintain their target market exposure while complying with these regulations, an investor will usually replace the sold asset with a similar but legally distinct investment.
Example
Suppose an Elephant holds two investments in a taxable brokerage account: shares in a peanut farming cooperative and shares in an acacia tree plantation. During the year, the Elephant sells the peanut shares for a profit of $5,000. If no other actions are taken, the investor owes capital gains tax on that entire $5,000 profit.
The acacia tree plantation shares have dropped in value and are currently worth $3,000 less than the Elephant originally paid for them. The Elephant decides to use tax-loss harvesting and sells the acacia shares to realize the $3,000 loss. By subtracting the $3,000 loss from the $5,000 gain, the Elephant reduces their net taxable capital gain for the year to $2,000. To stay invested in the forestry sector without violating tax rules against repurchasing the exact same asset immediately, the Elephant takes the cash from the acacia sale and buys shares in a baobab tree fund.