Form 1040

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Losing money on your investments is never fun, but there can be a silver lining when you sustain losses in a taxable investment account. Selling losing holdings to generate capital losses can feel good at tax time when you file your return, as it will reduce your taxable income within certain limitations. It can also increase the after-tax return that you realize in your portfolio over time.

When your investment drops in value

The benefits of harvesting tax losses can best be understood in the following example. If you invested $100,000 in a stock at the beginning of the year, and it dropped in value by 15% over the course of the year, then you would have $85,000 in the stock on Dec. 31. If you were to sell that holding, then you'd be sitting on a capital loss of $15,000. At the same time, you also sold some other stock at a $10,000 profit during the year, and you will have to report this gain as ordinary income on your tax return because you held the stock for less than a year before the sale. Here's where you can harvest a tax loss to offset this gain.

On Dec. 31, you call your broker or log into your investment account online and sell the depressed stock at its current price. You realize a capital loss of $15,000 on the sale. This amount can then be applied to cancel out the $10,000 gain that you realized from your other stock sale, so you will have no taxable capital gain to report on your return. On top of that, you can apply up to $3,000 of the excess $5,000 loss against other forms of ordinary income on your return that year. And any leftover losses carry forward to future years, so you can deduct the remaining $2,000 loss on your tax return the following year, assuming you don't realize any new capital gains during the year.

A couple of caveats

Bear in mind that you shouldn't sell a losing investment solely for the tax break. If a stock you own is down, but you still believe in the company's long-term potential to reward shareholders, then by all means, hang on to it -- or even buy more shares at the reduced price. And remember that your losses only exist on paper until you sell your position; then you lose money.

Lastly, there's a key rule you must follow in order to do enjoy the tax benefits of capital loss harvesting: You will have to wait for at least 30 days before you can buy the losing stock again. You cannot sell the stock in order to reap the deduction and then turn around and immediately buy it back -- nor can you purchase a "substantially identical" investment within that 30-day time frame. The IRS deems this a "wash sale," and it will not allow you to deduct your capital losses.

If 30 days go by and you decide to pick things up where you left them off, then you're free to repurchase that stock without violating the wash-sale rule. This can be an especially smart move if the stock's price has stayed flat or fallen further (and again, only if your long-term investing thesis is intact).

While tax-loss harvesting shouldn't be your top priority, it can certainly take the sting out of the losses you will inevitably experience as a stock investor. For more information on tax loss harvesting and how it can benefit you, consult your broker or tax advisor.

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