Over the last few weeks, I have been busy 1) rebalancing – including increasing exposure to the digital platform economy I discussed in my past post, 2) migrating from mutual funds to ETFs because of the latter’s tax benefit, and 3) tax loss harvesting.

Today I am gonna discuss tax loss harvesting. So what exactly is tax loss harvesting? It’s basically realizing a capital loss while maintaining the same exposure. For instance, if in your portfolio, there is a US equity fund with a $30k loss, you can sell the fund to realize the loss and buy a substantially similar US equity fund to take its place. This way you maintain the same exposure but book an accounting loss of $30k. This maneuver is called tax loss harvesting.

What’s the value of tax loss harvesting? The accounting loss you book can be used to reduce future income or capital gains tax. Rather counterintuitively, investment losses are thus an asset to be harvested. Let’s use an example to illustrate the point.

Let’s say you realized the $30k loss from selling the US equity fund. If you should realize a gain of $40k in the next year, instead of paying the 20% capital gains tax on all $40k, that is $8k, you can use your loss to offset the gain. You will end up paying only (40k-30k)*20% = $2k, resulting in a tax saving of 20%*$30k = $6k.

What if you don’t have any capital gains to offset? Fret not. You can use the loss to offset your income, but only up to $3000 per year. The unused portion of the loss can be deferred indefinitely into the future. So the $30k loss can be used to offset $3000 worth of income for the next ten years. For folks in the highest tax bracket, whose marginal tax rate – combined federal, state and local – is approaching 50%, the tax saving each year would be $1500, or $15k over ten years.

To sum up, with $30k of loss harvested, you will either save $6k in capital gains tax or $15k in income tax. Ex ante, we don’t know how we will use the loss, but if you just take the midpoint, the value of a $30k loss harvested is about $10k. What’s there not to like?

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