Tax loss harvesting is the process of intentionally incurring capital losses ("harvesting" them) in order to avoid paying taxes on capital gains. Tax loss harvesting is obviously only a viable tax avoidance strategy in jurisdictions, such as the United States, which allow capital gains to be offset by capital losses.
How it works
How does this work? Well let's say that six months ago you opened two equity positions for a total of $20,000, purchasing $10,000 worth of Stock A and $10,000 worth of Stock B. However, in the intervening year, Stock A has done quite poorly, and your position is now worth only $5,000, whereas Stock B has skyrocketed, and your holdings are now worth $15,000. Now then, let's say that for any of a number of reasons you have decided to sell your entire stake in Stock B. Maybe you really need the money, or maybe you just want to take your profit. The problem is, if you are a wealthy individual in a high income tax bracket, you would owe the government some large percentage of your $5,000 profit as a tax on capital gains - probably somewhere north of 30% (depending on which year it is and how powerful the Republicans are). However, if you also sell your stake in Stock A at the same time, you "harvest" the $5000 loss and your losses and gains offset each other, leaving you with zero net capital gain and thus owing no taxes.
Now some of you might think this sounds pretty silly. Why would you turn a $5000 profit into a break even situation by simultaneously locking in a $5,000 loss, just to save a bit of taxes?
This is a good question. Indeed, many investors become so obsessed with avoiding as much taxes as possible that they run around willy nilly locking in losses on positions that might well have recovered at a later date to a point of profitability far beyond what they saved on taxes. It is therefore generally best to only harvest losses on positions you were considering selling anyway.
However, there are all sorts of scenarios where tax loss harvesting makes a lot of sense, making it a crucial strategy for investors to increase their after-tax returns. In the US, for example, individuals can use up to $3,000 of capital losses per year to shield ordinary income from taxes, with the remainder of capital losses rolling over to the next year. Because ordinary income is currently taxed at a higher rate than long-term capital gains, it sometimes makes sense to harvest losses to offset ordinary income. However, you can only offset ordinary income after you have already offset any capital gains, so this only works if you have no capital gains or your harvested loss outweighs your gains. It also only makes sense if you are not that rich, since after a certain point the tax on $3,000 becomes a rounding error to the super-rich, who wouldn't even worry about this.
Another reason tax loss harvesting becomes useful is because the investor controls the timing of the loss. In the US, capital losses have to be first used to offset any gains of the same type, so long-term losses must first be used to offset any long-term gains, and short-term losses must first be used to offset and short-term gains. So if you have some long-term gains in one year, but expect to have no long-term gains the next year, it would be better to "save" the long-term losses on that one position you have that is way in the red until next year, when you can use it to offset some short-term gains or ordinary income, which are taxed at a higher rate than this year's long-term gains. Big losing positions, while a net suck for your overall portfolio, are potentially quite valuable for offsetting short-term gains, and should be saved and hoarded until just the right moment. At least that way you can get a little bit of that huge loss back in saved taxes. This is a strategy that anyone can benefit from, even the super-rich.
The "Wash Sale" Rule
Now going back to our example, those of you who are really clever will now be thinking, why not just sell all of Stock B for $5,000, harvesting a $5,000 loss, and then immediately buy it back for $5,000. That way, you would book the loss, but you would still own the stock and be in line to benefit from any future price appreciation. Although this is definitely an awesome idea, the problem is that the US government has foreseen this possibility, which is why there is something called the "wash sale rule." The wash sale rule says that if you sell a security, you cannot buy it back or another security substantially the same for at least 30 days and still claim a loss for tax purposes. If you do buy it back, it is a "wash sale" and you are considered to still have the original cost basis that you started with.
This is where the most common form of tax loss harvesting comes in -- the kind that rich people do. So there is a wash sale rule? Big deal. It's only 30 days. Just sell the stock, harvest the loss, and then buy it back 30 days later. While it is very possible that the stock price may climb in 30 days, it is almost equally possible that it will actually decline, which is all the better. And probably in most cases, it will sort of muddle along, being somewhere around the same price. In this case, you've succeeded in harvesting a loss without actually locking in a loss, so you've avoided taxes for free!
Or have you?
Here's the real kicker. This kind of tax loss harvesting does *not* actually avoid taxes. It just delays them to the future. Why? Because all you have really done is reduce your cost basis in Stock A. You avoid paying taxes on Stock B, but if you ever sell Stock A in the future for a gain, you are going to pay a much bigger tax on that gain than you would have, because now your cost basis is only $5,000 instead of the original $10,000. So unless you plan on never selling the stock, or possibly, donating the stock to charity, you are simply delaying your tax, not avoiding it, making tax loss harvesting in many cases a kind of bet that your tax rate might be lower in the future than it is now (which is generally true for most people, who have a lower rate in retirement than in the prime of their careers). However, due to the effects of inflation, if you wait long enough into the future to sell, the amount of tax you delayed will be reduced in real terms by inflation, leading to the expression "a tax delayed is a tax avoided." Essentially, you have gotten, in exchange for your large losses, a small, interest-free loan of indefinite duration from the IRS. Which is not quite the free money many people think it is, but also not nothing.
"Tax loss harvesting" gets a ton of airplay because many investors obsess about avoiding taxes to an insane and unhealthy degree, often at the expense of seeing the larger picture. Tax loss harvesting is not a magic bullet. For one thing, by definition you have to have losses, which means you screwed up somewhere. Second, in theory tax loss harvesting does not actually avoid taxes - it only delays them. However, a tax delayed may well become a tax avoided (or at least reduced) in time, and because of the investor's ability to control the timing of when the loss is harvested, the amount of tax delayed can be maximized, making tax loss harvesting a useful tool in any investor's toolkit.