Tax loss harvesting
Learn how tax loss harvesting works, the capital gains rules behind it, and why direct indexing tends to harvest more losses than ETFs.
Understanding tax loss harvesting
Tax loss harvesting is one of the main reasons customers choose direct indexing over investing in a single ETF or mutual fund. This article covers what tax loss harvesting is, how the capital gains rules that govern it actually work, and why direct indexing tends to generate more harvestable losses than an ETF-based approach.
How tax loss harvesting works
Tax loss harvesting is the practice of selling an investment that has dropped below its purchase price, realizing the loss for tax purposes, and reinvesting the proceeds in a similar, but not "substantially identical," investment so your market exposure stays roughly the same.
The realized loss becomes a line item you can use on your tax return. It can offset capital gains elsewhere in your portfolio, or a limited amount of ordinary income, and any amount you don't use carries forward to future tax years.
With direct indexing, Frec owns the individual stocks that make up your chosen index rather than a single ETF that tracks it. Frec's algorithm monitors your portfolio for harvesting opportunities and, when a stock drops below its cost basis, may sell it. Because the wash sale rule prevents immediately buying back the same stock, the proceeds are used to rebalance the rest of your portfolio toward the index, with any leftover cash invested in a correlated stock chosen to track the performance of the one that was sold. This happens automatically, without you needing to place any trades yourself.
Tax loss harvesting doesn't eliminate taxes. It defers them, generally to a later date and often at a more favorable rate, while letting you stay invested in the market the whole time.
Capital gains rules and limitations
To understand how much a harvested loss is actually worth to you, it helps to understand how the IRS treats capital gains and losses.
Short-term versus long-term
A gain or loss is short-term if you held the position for a year or less, and long-term if you held it for longer than a year. Short-term gains are taxed as ordinary income. Long-term gains are taxed at the capital gains rate, which is usually lower.
How losses offset gains
Losses first offset gains of the same type. Short-term losses offset short-term gains, and long-term losses offset long-term gains. If you have more losses than gains of one type, the excess can then offset gains of the other type. For example, $15,000 in long-term losses can fully offset $5,000 in long-term gains and $5,000 in short-term gains, leaving $5,000 in long-term losses still unused.
There's no cap on how much of a gain a loss can offset. If you have $200,000 in gains and $200,000 in losses, the two fully cancel out and you owe no capital gains tax on that amount.
The $3,000 limit, and the myth around it
Once your losses exceed all of your capital gains for the year, you can deduct up to $3,000 of the remaining loss against ordinary income (or $1,500 if you're married filing separately). It's a common misconception that $3,000 is the ceiling on what tax loss harvesting can save you each year. That limit only applies to the portion of a loss deducted against ordinary income after every capital gain has already been offset. Losses applied against gains carry no such cap.
Carryforward
Any loss you don't use in a given year, whether because you had no more gains to offset or you already hit the $3,000 income deduction, carries forward indefinitely to future tax years.
For a fuller walkthrough of these rules, including worked examples and how the numbers show up on your 1099 and tax return, see Filing your taxes: Turning tax losses into real dollar savings.
Tax outcomes depend on your individual circumstances. Frec doesn't provide tax advice, and we recommend consulting a qualified tax advisor about your specific situation.
How direct indexing differs from ETF-level harvesting
Some robo-advisors offer tax loss harvesting at the ETF level. They hold a small number of similar ETFs tracking the same broad index and, if one drops in value, they sell it and buy another to realize the loss.
This approach is limited by how few similar ETFs exist for a given index, and because an ETF's price reflects the average of everything underneath it, the whole fund generally has to decline before there's a loss to harvest. In a rising market, that opportunity can be rare or nonexistent even when many individual stocks within the index are down.
Direct indexing works underneath that surface. Because Frec holds the individual stocks in an index rather than a fund that tracks it, a harvesting opportunity exists whenever any one stock dips below its cost basis, regardless of what the index as a whole is doing. Individual stocks move independently of each other far more often than diversified funds do, which is designed to create meaningfully more harvesting opportunities over time.
In Frec's own simulations comparing a direct indexed S&P 500 portfolio to an ETF-to-ETF harvesting strategy (alternating between SPY and IVV) over a 10-year period, based on a one-time $50,000 deposit, direct indexing harvested approximately 1.9 to 2.1 times more losses. These figures are based on historical simulations, are hypothetical, and aren't a guarantee of future results. See the direct indexing versus ETF tax loss harvesting white paper for the full methodology.
Investing involves risk, including the risk of loss. Past performance and any hypothetical or simulated results do not guarantee future performance.
Fractional shares
Fractional shares support tax loss harvesting just like whole shares. Frec supports fractional share trading, including trades that occur within your direct indexing portfolio.