Tax-loss harvesting using ETFs: A guide

What Is Tax-Loss Harvesting?

We’ve established that capital gains tax is payable when you make a profit after selling an investment. The opposite is true. You can claim that as a tax credit to offset future gains if you sold and incurred a loss. Thank the IRS for this concession. 

There are some rules around it, though. A major one is the wash-sale rule, which states that when you sell a security at a loss, you cannot purchase one that is “substantially identical” to replace it within 30 days before the sale and 30 days after it’s complete. 

Unfortunately, the IRS does not offer a precise definition of what constitutes a “substantially identical security.” For ETFs, this definition generally applies to ones tracking differently named indexes (as disclosed in their prospectus), even if the indexes have similar holdings.

Examples of Tax-Loss Harvesting

Let’s assume I invested $100,000 in the S&P 500 through the Vanguard S&P 500 Index ETF (VOO). A year later, a bear market has caused my investment to dwindle to $80,000. 

To tax-loss harvest, I sell all $80,000 of VOO and lock in a $20,000 tax loss to offset future gains. I then immediately reinvest the $80,000 into another ETF that is not legally “substantially identical” to VOO. 

In this case, I chose the Vanguard Total Stock Market Index (VTI). You can use the ETF Central screener to find similar ETFs based on various criteria, such as geography, index, market cap, etc. 

VOO tracks the S&P 500 Index, while VTI tracks the CRSP US Total Market Index. This makes them sufficiently differentiated in the eyes of the IRS, even though VTI has a 0.99 correlation to VOO. 

The result? I now have $20,000 worth of capital losses to carry forth to offset future gains, thus reducing my tax liability. My $80,000 position in VTI will recover nearly identically to VOO, so I didn’t have to spend 30 days waiting on the sidelines in cash. 

Here’s another example. If I was investing in small-caps, I could sell the Vanguard S&P Small-Cap Value 600 Index ETF (VIOV) at a loss and immediately purchase the iShares Russell 2000 Value ETF (IWN). Both track substantially different indexes, yet are strongly correlated and have similar performance. 

Things To Note

Keep in mind that the above-noted examples are hypothetical. To determine whether two ETFs qualify as “substantially identical,” ensure you always consult a tax attorney or accountant. The information presented above is for general purposes only and should not be construed as legal or investment advice. 

There are other limitations too. First and most apparent, tax-lost harvesting only works in a taxable account. Doing this in a Roth IRA does absolutely nothing. You can’t tax-harvest losses when no capital gains tax is paid. The IRS also requires that gains are offset by the corresponding type of loss. That is, short-term losses must offset short-term gains, and vice-verse for long-term losses and gains. 

Finally, some always pertinent advice is “don’t let the tax tail wag the dog.” Tax loss-harvesting potential should be a secondary, not primary consideration when selecting an ETF for your investment portfolio. While beneficial to consider, more pertinent factors include the fund’s expense ratio, level of diversification, assets under management, volatility, and strategy.