Tax-Loss Harvesting: Tax Savings or a Disguised Deferral?

Every November, someone calls tax-loss harvesting "free money." It is a useful tool, but that description is only half right. In most cases, harvesting a loss does not erase tax. It moves tax to a later year. Whether that move leaves you ahead depends on your rates now, your rates later, and what eventually happens to the replacement investment.

If you want the mechanics and the direct indexing side of the topic, start with our earlier article, Advanced Strategies for Capital Loss Harvesting and Direct Indexing. This post focuses on when harvesting truly pays and when it does not.

Why Harvesting Usually Defers Tax

When you sell a holding at a loss and buy a similar investment, the loss reduces this year's tax. The replacement, however, has a lower cost basis than the position you sold. When you eventually sell the replacement, the gain is larger by roughly the amount of the loss you harvested. The tax comes back, just later.

Deferral has some value on its own, but the real question is what rate applies when the gain returns, and whether it returns at all.

Finding Losses After a Strong Market

After a strong run in stocks, many portfolios show few obvious losses. Look in less obvious places: bond funds, individual stocks or sectors that have lagged, and positions bought recently near a high.

Review holdings lot by lot, not just position by position. A stock showing an overall gain may include shares bought at a higher price that are now underwater. Treasury regulations allow you to sell those specific shares if you make an adequate identification. For shares held at a broker, that generally means telling the broker which lots to sell no later than the settlement date and receiving a written confirmation. A standing instruction for specific identification also counts. For individual stocks, if you do not identify lots, the default is first in, first out, which usually sells your oldest and lowest-basis shares.

Mutual funds work differently. Fund shares, and shares bought through a dividend reinvestment plan, may use the average basis method under Treas. Reg. § 1.1012-1(e), and many custodians default fund accounts to average cost. Because bond funds are a common source of losses right now, confirm the fund's basis method before you sell. Once shares have been sold under average cost, you can change methods only going forward, and the shares you already hold keep their averaged basis, so a switch generally helps only with shares acquired later.

When Deferral Turns Into Real Savings

Harvesting creates lasting value in three main situations.

1. Rate arbitrage. Capital losses are netted in a set order. Short-term losses first offset short-term gains, and long-term losses first offset long-term gains. Then the two net results are combined. If you end up with a net loss, you can deduct up to $3,000 of it against ordinary income each year ($1,500 if married filing separately), and carry the rest forward. That order limits the arbitrage. A loss on a position held more than one year is long-term, so it first absorbs long-term gains and saves only the 20% or 23.8% long-term rate, not your ordinary rate. Real arbitrage exists only when the harvested loss is short-term, or when a net long-term loss is left over to offset net short-term gains or the $3,000 of ordinary income. In those cases the loss saves tax at ordinary rates, while the deferred gain on the replacement may later be taxed at 15% or even 0%.

For 2026, the 0% long-term rate applies to taxable income up to $98,900 for married couples filing jointly and $49,450 for single filers. The 15% rate applies up to $613,700 joint and $545,500 single, with 20% above those amounts. The 3.8% net investment income tax (NIIT) may also apply when modified AGI exceeds $250,000 joint or $200,000 single. Those NIIT thresholds are not indexed for inflation.

Consider a hypothetical married couple in the 35% federal bracket, which for 2026 covers joint taxable income from $512,450 to $768,700. They harvest a $40,000 short-term loss that offsets $40,000 of short-term gains. At that income they are well above the NIIT threshold, so the loss saves 35% plus 3.8%, or $15,520, this year. Years later, they sell the replacement for $40,000 of extra long-term gain. If their taxable income that year stays at or below $613,700 (but modified AGI stays above $250,000), the gain is taxed at 15% plus 3.8%, or $7,520, and they come out $8,000 ahead on rates alone. If their taxable income in the sale year is above $613,700, the gain is taxed at 20% plus 3.8%, or $9,520, and the net benefit falls to $6,000. Because the 35% bracket straddles the $613,700 breakpoint, the sale-year income assumption matters as much as the harvest itself.

2. Step-up at death. Property inherited from a decedent generally takes a basis equal to its fair market value at the date of death. If the low-basis replacement is still held at death, the deferred gain disappears for the heirs. For California married couples, community property can be especially valuable here: when one spouse dies, the surviving spouse's half of qualifying community property can also receive a new basis.

Death cuts the other way for losses. Capital loss carryforwards do not pass to the estate or the heirs. Unused losses can be deducted only on the decedent's final return, and on a joint return the portion of a carryforward that belonged to the deceased spouse expires after the year of death. For older clients, harvesting a loss that will only be carried forward may produce little value, because the carryforward can die unused while the step-up would have erased the gain on the original position anyway.

3. A charitable exit. If you give the low-basis replacement shares to a public charity or donor-advised fund after holding them more than one year, you generally deduct their fair market value and never pay tax on the gain. Deductions for appreciated capital gain property given to public charities and donor-advised funds are generally limited to 30% of AGI, with a five-year carryforward for any excess. Starting in 2026, itemizers also face a new floor equal to 0.5% of AGI. For taxpayers in the 37% bracket, the new § 68 limitation also caps the tax value of itemized deductions, including this charitable deduction, at 35 cents per dollar. California has not adopted the 0.5% floor. See our post on the 2026 charitable floor and giving before December 31.

The Other Side: Harvesting Gains at 0%

The deferral logic also runs in reverse. If your taxable income is low enough, you can harvest gains instead of losses. Married couples with taxable income below $98,900 for 2026 ($49,450 for single filers), counting the gain itself, can sell appreciated shares, pay 0% federal tax on the long-term gain, and buy the same shares right back to reset the basis higher. The wash sale rule applies only to losses, so an immediate repurchase is allowed. This can make sense in a gap year between retirement and required distributions or Social Security. For California residents, the gain is still taxed as ordinary income on the state return, and the higher AGI can affect Medicare premiums two years later, so run both numbers first.

The Trap: Paying It Back at a Higher Price

Deferral can backfire. If you sell the replacement in a year when your income is higher, the deferred gain can be taxed at 20% plus the 3.8% net investment income tax. And if you sell the replacement within one year of buying it, the deferred gain is short-term and taxed at ordinary rates, which wipes out the arbitrage entirely.

Medicare premiums add another layer. Higher-income beneficiaries pay an income-related monthly adjustment amount (IRMAA) on Part B and prescription drug coverage, and Social Security sets it using the tax return from two years earlier. A gain you realize in 2026 drives your 2028 premiums, measured against 2028 thresholds, which are adjusted for inflation. For reference, 2026 surcharges start when 2024 modified AGI exceeds $109,000 single or $218,000 joint. The tiers are cliffs, not phase-ins: one dollar over a threshold triggers the full surcharge for that tier for the entire year. A large gain realized at 63 or later deserves a look at where it lands against those tiers.

The Wash Sale Rule and the IRA Trap

A loss is disallowed if you buy substantially identical stock or securities within 30 days before or after the sale. That creates a 61-day window centered on the sale date. Purchases by your spouse or by a corporation you control can also trigger the rule, and automatic dividend reinvestment counts as a purchase. Normally the disallowed loss is not lost forever. It is added to the basis of the new shares, and the holding period of the old shares carries over, so you recover it later.

The exception is your IRA. Under Revenue Ruling 2008-5, if your IRA or Roth IRA buys substantially identical securities within the window, the loss on your taxable account sale is disallowed, and the basis in your IRA does not increase. The loss is effectively gone for good. Coordinate every account in the household, including retirement accounts, before you harvest.

Digital assets are a moving target. Section 1091 reaches stock and securities, and the IRS treats virtual currency as property, so under current law selling a cryptocurrency at a loss and buying it back has not triggered the wash sale rule. Congress is working to change that. H.R. 9172, the Applying Existing Tax Anti-Abuse Rules to Digital Assets Act, was introduced on June 8, 2026, and the broader Digital Asset Tax Certainty Act, H.R. 10357, was approved by the House Ways and Means Committee on September 16, 2026. Both would extend the wash sale rule to most digital assets other than qualified dollar stablecoins. As introduced, both apply to sales after the date the bill was introduced, not the date of enactment, so a crypto harvest done this year could be caught retroactively if that language survives. A Senate version, S. 5616, would apply only after enactment. None of these bills is law yet, so if you harvest digital asset losses this year, keep the repurchase outside the 61-day window or document the risk.

The California Angle

California taxes all capital gains as ordinary income. There is no lower long-term rate. That changes the analysis for California residents:

• Rate arbitrage is mostly federal. A harvested loss saves California tax at your ordinary rate now, which reaches 13.3% on taxable income above $1 million (the 12.3% top rate plus the 1% Behavioral Health Services Tax, formerly the Mental Health Services Tax). The deferred gain is taxed at an ordinary rate later. For California purposes, the benefit is mainly timing, unless your income or your state of residence changes.
• A move can make the timing benefit permanent. Gain on stock and other intangibles is generally sourced to your state of residence when you sell. If you sell the replacement after a bona fide move out of California, the deferred gain generally falls outside California's reach, turning the state timing benefit into permanent savings. The part-year residency rules in R&TC § 17041(i) still apply in the year you move, and the FTB looks closely at residency changes, so the move has to be real.
• The $3,000 limit applies. California also limits a net capital loss deduction to $3,000 ($1,500 for married or RDP filing separately).
• The wash sale rule applies. California incorporates the federal wash sale rule, so a disallowed federal loss is generally disallowed for California as well.

A Practical Checklist

• Estimate your 2026 gains, including fund distributions, and sort them into short-term and long-term.
• Review each lot, and set specific identification with your custodian before you sell. For mutual funds, confirm whether the account uses average cost.
• Pick a replacement that keeps your market exposure without being substantially identical.
• Check every household account, including IRAs, for purchases within 30 days before or after the sale.
• Plan to hold the replacement more than one year. In a clean harvest, the replacement starts a new holding period, and a sale within a year turns the deferred gain into a short-term gain taxed at ordinary rates.
• Decide what you expect to happen to the replacement: hold until death, give to charity, or sell in a lower-income year.
• For older clients, weigh whether a loss will be used during life or only carried forward.
• Model future years for the 20% bracket, the net investment income tax, and IRMAA two years out.
• If taxable income is low this year, consider harvesting gains at 0% instead.

For other moves to make before December 31, see our 2026 year-end tax planning checklist.

Sources

• IRS Publication 550, Investment Income and Expenses
• 26 U.S.C. § 1091, Loss from Wash Sales of Stock or Securities
• Revenue Ruling 2008-5
• 26 U.S.C. § 1211, Limitation on Capital Losses
• 26 U.S.C. § 1222, Other Terms Relating to Capital Gains and Losses
• 26 U.S.C. § 1223, Holding Period of Property
• 26 U.S.C. § 1014, Basis of Property Acquired From a Decedent
• Treas. Reg. § 1.1012-1(c) and (e), Sale of Stock and Average Basis for Fund Shares
• IRS Publication 559, Survivors, Executors, and Administrators (with Rev. Rul. 74-175)
• Revenue Procedure 2025-32, 2026 Inflation Adjustments
• IRS Topic 559, Net Investment Income Tax
• IRS Publication 526, Charitable Contributions
• 26 U.S.C. § 68, Overall Limitation on Itemized Deductions
• Social Security Administration: Medicare Premiums for Higher-Income Beneficiaries
• IRS Notice 2014-21, Virtual Currency Treated as Property
• H.R. 9172, Applying Existing Tax Anti-Abuse Rules to Digital Assets Act
• H.R. 10357, Digital Asset Tax Certainty Act
• FTB: Capital Gains and Losses
• FTB: 2025 Instructions for California Schedule D (540)
• FTB: 2025 Instructions for Form 540 (Behavioral Health Services Tax)
• FTB Publication 1100, Taxation of Nonresidents and Individuals Who Change Residency
• FTB: Summary of Federal Income Tax Changes (0.5% charitable floor)

Key Takeaways

• Tax-loss harvesting usually defers tax, because the replacement holding carries a lower basis.
• Rate arbitrage is real only when the harvested loss is short-term or spills over to short-term gains or ordinary income; a long-term loss first absorbs long-term gains.
• Lasting savings come from rate arbitrage, a step-up at death, or a gift of appreciated shares to charity, but loss carryforwards expire at death.
• Hold the replacement more than one year, and model the sale year: the 20% rate, the 3.8% NIIT and IRMAA, which looks back two years and works as a cliff, can erase the benefit.
• A repurchase in your IRA within the wash sale window can eliminate the loss permanently, and pending bills could extend the wash sale rule to digital assets retroactively.
• In a low-income year, harvesting gains at 0% and buying back immediately can reset basis.
• California taxes capital gains as ordinary income, up to 13.3%, so the state benefit is mostly timing unless you sell the replacement after a bona fide move out of state.

If you want your 2026 gains and losses reviewed before you harvest, schedule a consultation with SMB CPA Group. You can also contact us, learn about our custom scope of work, or review our pricing.

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