Brian Lee
Jun 31, 2025
This article may upset you if your income comes from a W-2 job. While the U.S. tax code is written to encourage investment in the economy, nobody tells you the truth. It keeps you enslaved. This is why knowledge is power. Do not let the government and financial institutions exploit your honest labor through systems designed to benefit them. Learn the rules, and use them to your advantage.
Before exploring more advanced trading strategies, it is essential to understand tax loss harvesting—a foundational concept in managing portfolio tax liability. Tax loss harvesting is the practice of selling securities at a loss to offset capital gains, thereby reducing the amount of taxable income. When applied strategically, it can allow investors to generate income that is legally tax-free.
To appreciate the benefit of tax loss harvesting, one must first understand how capital gains tax works. When you sell a security for more than your purchase price, the profit is considered a capital gain. The tax rate applied depends on the holding period. If the asset was held for one year or less, the gain is classified as short-term and taxed at ordinary income rates. If the holding period exceeds one year, the gain is long-term and taxed at a lower, preferential rate.
By realizing losses in positions that have declined in value, you can reduce or eliminate your taxable capital gains. This technique forms the backbone of my approach to managing both stock and options positions. The goal is not merely to maximize profit but to optimize the tax impact of trading activity.
A related concept is the wash-sale rule, a U.S. tax regulation that can disallow certain losses if the same or substantially identical security is repurchased within 30 days. Although not complex in itself, understanding the wash-sale rule requires a solid grasp of tax loss harvesting. I will address the wash-sale rule in a separate article.
Gains and losses fall into two major categories: realized and unrealized. Distinguishing between them is fundamental to applying tax strategies effectively.
Before diving into the definitions, it is important to understand cost basis. The cost basis of an asset is generally the original purchase price, including any commissions or fees paid. It represents the amount you have invested in the asset for tax purposes. When the asset is sold, your gain or loss is calculated by subtracting the cost basis from the sale price.
Realized Gain (RG) occurs when an asset is sold for more than its cost basis. This gain is subject to tax in the year the sale takes place.
Realized Loss (RL) occurs when an asset is sold for less than its cost basis. This loss can be used to offset realized gains, reducing the taxable amount.
Unrealized Gain (UG) represents an increase in the value of an asset that has not been sold. These gains are not taxable until they are realized through a sale.
Unrealized Loss (UL) is a decline in the value of a held asset. Like unrealized gains, these losses do not affect your tax position until the asset is sold.
The essence of tax loss harvesting lies in creating a mix of RG and RL such that their sum is zero or negative. If realized losses exceed realized gains, the resulting net capital loss can be used to reduce your tax liability. However, the benefits depend on the nature of your income.
The rules governing capital loss deductions highlight the disadvantages of earning ordinary income, particularly W-2 wages. The IRS allows only up to $3,000 of realized capital losses per year to be applied against ordinary income. Any losses beyond this limit must be carried forward to future years.
In contrast, if your income comes entirely from investments, the rules are far more favorable. Capital losses can fully offset capital gains, without a cap, and excess losses may be carried forward indefinitely. This flexibility allows you to realize losses greater than gains year after year, paying no tax while your portfolio continues to appreciate through unrealized gains.
This tax deferral and compounding effect is central to the strategy I use in trading stocks and options. It enables legally “losing” money on paper to reduce tax liability, while still achieving long-term portfolio growth.
For tax loss harvesting to be viable, it is necessary to hold multiple positions. A single-stock portfolio does not provide the flexibility required to strategically realize losses while maintaining overall exposure. Therefore, diversification is not only prudent—it is essential to the successful execution of this strategy.
Consider a simple trading strategy involving two stocks: TSLA and NVDA.
In this hypothetical case, TSLA generates $2 per month in total gains—$1 realized and $1 unrealized. Meanwhile, NVDA produces an unrealized loss of $1 per month.
Realizing NVDA’s losses early in the year is not ideal, as there is a possibility the stock may recover. Therefore, for the first six months, I accumulate unrealized losses in NVDA. Beginning in July, I start realizing $2 of losses per month—$1 from the current month’s loss and $1 from the previously accumulated unrealized losses—to offset the realized gains from TSLA.
By the end of the year, the strategy results in $12 of realized gains from TSLA and $12 of realized losses from NVDA. This completely offsets the taxable gains, reducing the capital gains tax liability to zero. At the same time, the portfolio has increased in value by $12 through unrealized gains. This also means you can spend the $12 of realized gains without incurring any tax.
Definitions:
| M | RG | RL | UG | UL |
|---|---|---|---|---|
| Jan | 1 | 0 | 1 | -1 |
| Feb | 1 | 0 | 1 | -1 |
| Mar | 1 | 0 | 1 | -1 |
| Apr | 1 | 0 | 1 | -1 |
| May | 1 | 0 | 1 | -1 |
| Jun | 1 | 0 | 1 | -1 |
| Jul | 1 | -2 | 1 | 0 |
| Aug | 1 | -2 | 1 | 0 |
| Sep | 1 | -2 | 1 | 0 |
| Oct | 1 | -2 | 1 | 0 |
| Nov | 1 | -2 | 1 | 0 |
| Dec | 1 | -2 | 1 | 0 |
| Tot | 12 | -12 | 12 | 0 |
This is why I often say that we’re enslaved by the system. Those earning W-2 income are structurally disadvantaged when it comes to tax strategy. In contrast, the wealthy understand and utilize the rules to their advantage.