Can You Profit From Year-End Tax Loss Harvesting?

There's an interesting end-of-year strategy in the stock market that investors can benefit from in two distinct ways.

It's called tax loss harvesting, and it refers to the relatively common strategy of selling off underperforming stocks or other assets at the end of a calendar year for a loss. Those losses can then be used to offset capital gains accrued during the year and lessen an investor's taxable investment income, and thus their taxes.

Investors often take the money that resulted from the asset sales and reinvest it into a similar investment -- for example, selling an underperforming energy stock and using the proceeds to purchase a similar energy stock, possibly one that also looks cheap at the moment.

There are two important caveats to consider, however. First, the strategy can only be applied to taxable accounts and investments. So it's not applicable to tax-advantaged accounts like 401(k)s and IRAs.

Second, the IRS also has a so-called wash sale rule that prohibits investors from gaming the system by repurchasing the same asset they've just sold or are about to sell (30 days before the sale and 30 days after). That rule also applies to the investor's spouse. And note that you can use tax loss harvesting to offset a maximum of $3,000 of income per year.

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Another way to benefit

Yet there's another potential benefit from the tax loss harvesting phenomenon that often takes place in December. There are often some underperforming stocks that get so beaten down by investors selling them to harvest losses that they fall to new lows that don't reflect their true values.

Those same stocks will then appear to be on sale -- worth more than they cost -- to many other investors, who will start buying them in the new year. So there will likely be a chance over the next couple of weeks to buy many stocks suddenly trading at a discount and watch them rally in the new year. There's even a name for this phenomenon: the January Effect, which is the rise of certain stocks that have sold off in December and are then repurchased in January.

One way to identify these stocks is to look for the worst performers over the first half of December and then try to determine if their sell-off is justified by some new information or development. If not, these stocks may be the ones with the most potential to rebound in January.

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