It occurs when an investor sells a security that has depreciated in value only for the tax losses.
[1][2] The effectiveness of this approach is dependant of the tax rules in a particular jurisdiction.
In the United States CBS News describes tax loss harvesting specifically as "selling an investment at a loss with the intention of ultimately repurchasing the same investment after the IRS's 30 day window on wash sales has expired."
This allows investors to lower their tax amount with the use of investment losses.
[3] Tax loss harvesting can be done throughout the fiscal year but historically has been performed in December.
[4] Tax-loss harvesting is still most common in the year's fourth quarter.
[6] Loss harvesting defers taxes, but doesn't eliminate them, and is essentially receiving a loan without interest from the federal government, assuming marginal tax rates are the same.
[7] If marginal rates are different, then there can be additional tax savings (e.g., deducting excess losses against a higher ordinary income rate in one year in exchange for additional long term capital gains tax at a lower rate in a later year) or even a tax penalty (e.g., deducting at a lower capital gains tax rate in several years in exchange for a much larger gain in one later year that puts one in a higher capital gains tax and Medicare investment income tax bracket.
)[8] The practice of tax loss harvesting has been both praised and criticized by investors, as deferring the taxes can result in higher rates later on relating to capital gains.
[8][9] Most simply, if "tax-loss harvesting is not done properly, it will create a wash-sale that will eliminate the tax benefits of the buying and selling".
[10] The investor can employ a number of techniques to avoid triggering the wash sale rule.
The United States Internal Revenue Service (IRS) has published no exact definition of what constitutes a "substantially identical" security.
As a result, if an investor trades in and out of Exchange-traded funds (ETFs) or mutual funds with almost identical holdings, some have held that it does not trigger the wash sale rule.
If an investor purchases shares in SPY and the market price declines, the IRS has not provided guidance on whether the investor can sell their shares in SPY, purchase shares in IVV, and claim a capital loss without triggering the wash sale rule, despite the fact that the two ETFs have nearly identical returns.
, it is possible to do TLH within the confines of mean-variance optimization by developing an objective function[17] that maximizes the difference between tax alpha and the portfolio's tracking error:[18]