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My colleague Sue Thompson recently pointed out that “investment losses are not always a bad thing,” and she described how investors can benefit from tax loss harvesting—selling money-losing investments in order to decrease tax liabilities. Sue focused on the psychological difficulty many investors have in selling an unprofitable investment. I’d like to talk specifically about using investment losses to lower your tax bill.

Tax loss harvesting is actually pretty straightforward: The federal tax code allows investors to use losses on investments—known as capital losses—to reduce your income and thus lower the amount you pay in taxes.

It works like this: Say you’ve invested $15,000 in a taxable account that has lost 20% of its value. So you sell the investment and take a $3,000 capital loss.

Nobody likes to lose money, of course. But you can at least put that loss to good use. The government allows taxpayers to subtract capital losses from capital gains, so if you have $3,000 in taxable capital gains for the year, you can negate that capital gain with your $3,000 in capital losses.

If you didn’t have any capital gains, you can then subtract up to $3,000 a year in capital losses from your ordinary income. (If you’re married but filing separately, the amount is reduced to $1,500.) And if your capital losses exceed $3,000, you can roll the excess over into future years, taking up to a $3,000 capital loss annually until the original total loss has been used up.

To ensure that you don’t sell at a loss, get the tax break, and then instantly buy back your original investment, the government has what’s known as a “wash sale” rule. The rule mandates that, in order to get the tax break, you cannot claim a loss on the sale of an investment and then buy substantially the same investment within 30 days either before or after the sale.

But it is legal to buy an investment product that brings similar — though not identical — market exposure as the product you just sold. (IRS rules are a little vague on the subject; it’s a good idea to discuss this strategy with your tax or financial advisor.) That way, if the market goes down, at least you still have the capital loss to lower your taxes, and if the market goes up, you have both the capital loss and market exposure similar to what you had before selling your original investment.

There are some nuances to tax loss harvesting, so it’s absolutely a good idea to consult with your tax or financial adviser before making any moves. But with the end of the year fast approaching, now’s the time to have that conversation. For many investors, tax loss harvesting is a sensible way to take some of the sting out of investment losses by reducing their tax bill at the same time.

Disclaimer: The IRS has not released a definitive opinion regarding the definition of “substantially identical” securities. The information and examples provided are not intended to be a complete analysis of every material fact respecting tax strategy and are presented for educational and illustrative purposes only. Tax consequences will vary by individual taxpayer and individuals must carefully evaluate their tax position before engaging in any tax strategy.

Source: From Pain To Gain: Using Investment Losses To Lower Your Tax Bill