One possible upside to a down market comes in the form of a long-recognized strategy called tax loss harvesting. The concept took a backseat in the midst of an 11-year bull market, but it has jumped back into discussion now.

Given the dramatic drop in investment markets in 2020, many investors may hold positions in stocks that have lost ground. In the right circumstances, generating a tax loss by selling specific securities may be advantageous. Hereís what you should know:

A potential tax-saving strategy

The tax loss harvesting strategy applies specifically to investments held in taxable accounts. Since current taxes aren’t applied to IRAs or workplace retirement plans, this strategy is not applicable in those accounts.

The tax benefit of selling a security in a loss position is that those losses could potentially reduce your tax liability. Suppose you invested $10,000 to buy 1000 shares of a stock for $10 per share more than a year ago. Today, if the stockís value dropped to $8 per share, your initial investment is now valued at $8,000. The stock may recover and eventually appreciate in value. But if you sell it today, you could claim a $2,000 long-term capital loss. Is that the right choice?

The upside of tax-loss selling

One deciding factor is whether you have investment gains that can be offset by the losses you incur from selling securities in a negative position. Long-term capital gains you claim are taxed at rates of 0, 15, or 20 percent based on your federal tax return. If you had a $3,000 long-term capital gain to claim on your 2020 tax return, that would come with a federal income tax bill of $450 if your long-term capital gain is taxed at the 15% rate. If you lock in a $3,000 long-term capital loss, it will offset that gain and eliminate any tax liability with respect to the capital gains.

Likewise, if you own mutual funds in a taxable account, they may pay out capital gains distributions this year, even if they are not performing well at the present time. Those gains too can be offset by capital losses you claim.

Note that you may not need or want to offset capital gains if your taxable income, including the gains, is $40,000 or less for single tax filers or a married taxpayer filing separately, or $80,000 or less for a married couple filing a joint return. Taxpayers with income and gains below those income thresholds qualify for a 0% tax rate on long-term capital gains.

Singles and married couples filing a joint return can use up to $3,000 of net capital losses to offset ordinary income ($1,500 for a married, filing separately, tax filer). Beyond that, unused losses can be forwarded to offset potential taxable capital gains in future tax years.

Cautions about tax loss selling

The downside to selling a position that has suffered a loss is that you can’t purchase that specific security or one that is “substantially identical” 30 days before or after the sale at a loss. Choosing to sell also means you sacrifice the potential to benefit from a rebound in the price of the security. You want to be certain that you are comfortable not owning a specific security for a period of time that could be a candidate for tax loss harvesting.

Most of all, any buy-or-sell decisions you make regarding your portfolio need to go beyond just the tax consequences. Talk to your financial advisor about how tax loss harvesting opportunities fit into your overall financial plan. Be sure to consult with your tax advisor as well to understand how tax rules apply.