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Investment losses, part 2: What is tax-loss harvesting?

Let's continue the discussion of tax losses we began in our previous post.

As we noted last week, tax laws allow for certain deductions for investment losses. In this part of the post, let's look at an example of a sophisticated strategy called tax-loss harvesting that some taxpayers use to make the most of these deductions. What is this exactly?

Tax-loss "harvesting" involves selling stocks, bonds or mutual funds at a loss, and then buying a similar instrument in the hope of getting gains in the future. If all goes well, you could deduct a loss, offset other income, and be positioned to get tax-deferred profit in the longer term.

Tax specialists encourage investors to take full advantage of approaches like this. But you don't want to overplay your hand, either. If you do, you could end up hurting, rather than helping, your tax position.

For example, suppose you sold an investment at a loss and took the tax deduction for investment losses allowed by law. And then, to implement the "harvesting" strategy, you bought a similar instrument, looking toward a future gain where you'd get a tax break on the profit.

Even if the investment does perform well, you could end up paying more capital gains tax than you might have otherwise. This is because your purchase may have reset the tax basis of the investment in a way that increases the potential tax later.

How this all would play out depends a lot on your tax bracket. But it is something to be aware of.

Getting tripped up by complicated IRS rules on tax losses is also a possibility. That is why it is important to get counsel from a skilled tax attorney when considering a sophisticated strategy like tax-loss harvesting.

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