What it is:
Tax selling is a strategy used to reduce tax liability.
How it works (Example):
Let's assume that John sold two different stocks that he originally bought five years ago:
1) He sold 1,000 shares of Company XYZ at $25 a share. He originally bought them for $15 a share.
2) He sold 1,000 shares of Company ABC at $40 a share. He originally bought them for $20 a share.
In order to reduce that hefty tax bill, John could take the opportunity to do some tax selling. The idea is that he could unload some of the dog stocks that he's been hanging on to and reduce the capital gains he pays taxes on.
For example, John still owns 200 shares of Company DEF, which he bought for $30 a share. Today, the shares sit at $15 a share, with little hope of recovery. If John sells those shares, he'll take a capital loss of $15 x 200 = $3,000.
This loss is tax-deductible. That means, he can use it to offset some of his gains and thereby reduce his taxes. Accordingly, instead of paying $4,500 in taxes, John would pay:
$30,000 gain - $3,000 loss = $27,000 net gain
$27,000 net gain x 15% = $4,050 taxes owed, net of tax selling
Tax selling saves him $450 in taxes.
Why it Matters:
Tax selling is commonplace in most investors' year-end tax planning, and accordingly, the markets often experience considerable sell-offs in the month of December.
Generally-speaking, the IRS requires investors to net short-term gains and short-term losses against each other, and net long-term gains and long-term losses against each other. The IRS also typically limits the deduction for capital losses to $3,000 a year.
It is important to note that the IRS is aware that the deductibility of investment losses might tempt investors to sell at a loss, deduct the loss, and then turn around and buy the same stock again in an effort to evade taxes. This practice is called a wash sale, and the IRS has wash sale rules in place to prevent investors from selling and buying back stocks to avoid paying taxes.