How does tax loss harvesting work?

Tax loss harvesting is a strategy that involves selling investments that have incurred a loss to offset capital gains realized during the tax year. The fundamental concept behind this practice is to use the losses to reduce the taxable income generated by capital gains, which can ultimately lower an individual’s or entity’s tax liability. This is particularly beneficial in the context of capital gains taxes, as it allows investors to strategically manage their investment portfolios while optimizing their tax positions.

By realizing these losses through the sale of underperforming assets, investors can balance out the gains from other successful investments, resulting in a net capital gain that may be significantly lower than if the losses had not been engaged. This not only helps in managing the current year’s tax burden but can also carry forward any unused losses to future tax years, providing ongoing tax benefits.

This approach is generally applicable to individual and institutional investors rather than being exclusive to large corporations, allowing a wide range of taxpayers to take advantage of tax loss harvesting. Thus, the answer accurately reflects the mechanism of tax loss harvesting as a valuable tool in tax planning and investment strategy.