Sometimes we make bad bets.
Make a bad bet in a casino, you might leave with a drink. Make a bad bet in the stock market, you can leave with an income tax deduction.
If that made you say “huh? what?” — perk up.
It's called tax loss harvesting and it's what successful investors use to help juice up returns on their investment.
You can think about your public market investment portfolio as a business. When you sell a winner, you have profit (capital gains). When you sell a loser, you have loss (capital loss). Capital gain is offset by capital loss and you are taxed on the difference between the two.
For example, if I bought $10,000 worth of Wallet Hacks stock in January and sell it for $20,000 in March, that's a $10,000 short term capital gain. If I also bought $10,000 worth of Money Boss stock in January but sold it for just $5,000 in December, that's a $5,000 short term capital loss (sorry buddy!).
$10,000 of gain minus $5,000 of loss means I will be taxed on $5,000 of gain at the short term capital gains rate.
I cash out my winner because I want to lock in the paper gains, but I want to lower my tax burden so I need to find a loser I can sell to help offset those gains. Boom, found a good candidate and I sell it to lock in the losses.
The IRS and Treasury Department know people do this. So they create a rule, you can't use the loss to offset gains unless you follow specific guidelines. Those guidelines are referred to as the “wash-sale rule.”
The wash-sale rule says that if you buy the same or “substantially identical asset” within 30 days, you won't be able to use the loss. The loss gets added to the tax basis of the new holding, so it in effect just gets delayed until you sell the stock again. The loss doesn't disappear. (funny enough, your new holding is actually an extension of your old holding, which you sold at a loss, so it could be eligible for long term capital gains rates)
After I sell Money Boss stock, I can't buy back in for 31 days if I want to offset my gains with that loss. I can buy another asset, maybe pick up shares of The Penny Hoarder or Wise Bread (I hear those two blogs are going places!), but I can't buy Money Boss. (the same rule applies for 30 days before the loss sale, so I can't buy Money Boss 30 days before I sell my losing position)
One final rule to remember – if you have more losses than gains, you can use up to $3,000 of those losses to offset ordinary income. Any extra losses above $3,000 get carried over to the next year.
How the rich use this strategy
It all comes down to the term “substantially identical.” There are plenty of mutual funds that, if you asked a regular human being, are pretty much the same.
To IRS regulations, they are not. Take a look at these two funds:
Vanguard 500 Index Fund and the Vanguard Total Stock Market Index fund are two different funds but they're very close. The S&P500 makes up around 75% of the market so we have a lot of good overlap. If you were looking at a loss this year in the S&P500 fund, you could harvest those tax losses and put them into the Total Market fund. Wait 31 days, then go back to the S&P 500 fund.
(Michael Kitces has a good discussion of the substantially identical rule as it relates to the intent of the rule, pooled investment vehicles, and loss harvesting — read it)
When the market took a nosedive in 2008 and 2009, I know a lot of folks who harvested losses. Tens of thousands of dollars, if not into the hundreds of thousands, of losses. But they participated in the upside when the market recovered because they purchased something similar, albeit not “substantially identical.”
Now before the pitchforks come out, remember that the losses suffered are very real. This isn't some crazy loophole that makes the rich richer (look up carried interest for that). It just makes them a little bit more richer because you get a small tax benefit in the interim.
All of the tax benefits, very little risk you'll miss some upside move by the S&P500 that isn't captured by the Total Market fund.
Realizing paper losses may hurt psychologically but it's a boon financially. If your $10,000 investment is only worth $5,000, selling it doesn't mean you lost $5,000 right now. You lost it a long time ago, you're just now able to reap some of the silver lining in that loss. $3,000 can go towards offsetting ordinary income and the rest can be used to offset any capital gains you've already realized.
If you read Kitces' article, tax loss harvesting has a lot of murkiness around “substantially identical” but it's a powerful tool many folks are using and you should be using too.