Don’t let the hot performing stock market of 2021 fool you. Odd as it may seem, some investors are sitting on losses in individual stocks or funds that have sharply declined. How can they turn their lemons into lemonade?

Tax-loss harvesting offers a fresh approach for dealing with unprofitable trades. The strategy allows investors with losing investments in a taxable brokerage account to clean up their portfolio while taking full advantage of the current tax rules.

“Tax-loss harvesting has a very real and meaningful positive impact on the after-tax return of an investor as realized losses can be used to offset gains from elsewhere in a portfolio,” said Kevin T. Carter, founder of the Emerging Markets Internet & Ecommerce ETF (EMQQ) and the Next Frontier Internet & Ecommerce ETF (FMQQ). “This will ensure that the investor maintains the exposure they are seeking but also get the tax benefit of the realized loss.”

Let’s examine a few examples of 2021 candidates for tax-loss harvesting.

Chinese Stocks And ETFs
The Chinese stock market has been hit hard in 2021 by regulatory interference, by slowing economic growth and by tense trade relations with the U.S.

“Despite another stellar year for U.S. markets, there’s plenty of opportunity to capture tax losses,” said Mike Akins, founding partner at ETF Action. “At our firm, we’re working with clients to screen holdings across emerging markets, the Asia-Pacific region and 2020 thematic winners that have experienced significant drawdowns from 52-week highs.”

One of the funds that’s been crushed by the 2021 turmoil is the KraneShares CSI China Internet ETF (KWEB); it’s one of the worst-performing emerging market funds, having fallen 43.48% year to date.

But for investors sitting on losses in the fund, not to mention individual stocks like Alibaba Group that have also been clobbered, there’s a way out.

Replacing losing China funds and stocks with Carter’s EMQQ fund offers investors exposure to the China internet sector while also allowing them participation in the growing internet and e-commerce markets in India, Brazil and other fast-growing emerging countries.

Also, investors replacing a losing Chinese stock with EMQQ will achieve broader diversification without breaking wash-sale tax rules.

The SPAC Market
A record 565 special-purpose acquisition companies (SPACs) launched this year. And while the SPAC market had a few stellar performers like Lucid Motors and Grid Dynamics, some SPACs are trading at or below their pre-merger price.

A potential solution for dealing with money-losing SPACs is to swap the stinkers with the Defiance Next Gen SPAC Derived ETF (SPAK). The fund offers diversified exposure to a basket of 315 different SPACs. And if an investor is still bullish on the evolving marketplace for these entities, SPAK provides a good way to participate.

High-Growth Funds
It’s no secret that thematic growth funds like the ARK Innovation ETF (ARKK) and ARK Genomic Revolution ETF (ARKG) have been hammered this year. The innovation fund has lost 20% year-to-date, while the genomics fund has lost 35%. Investors chasing the hot performance in 2020 are now likely sitting on losses.

Similar ETFs with an indexing approach could be a good solution for replacing losing trades in these two funds.

The Direxion Moonshot Innovators ETF (MOON) follows a similar thematic approach as ARKK but with slightly better 2021 performance. Plus, MOON charges a slightly lower expense ratio than ARKK does, which saves investors money.

The ALPS Medical Breakthroughs ETF (SBIO), meanwhile, could be a good replacement for ARKG. Rather than concentrating exposure on genomics stocks, SBIO takes a broader approach by focusing on U.S.-listed small-cap biotechs with one or more drugs in Phase II or Phase III of clinical trials for the U.S. Food & Drug Administration. As a bonus, SBIO charges lower annual expenses of just 0.50% while the ARK genomics fund charges 0.75%.

Summary
Keep in mind that the IRS allows a tax deduction on capital losses up to $3,000 per calendar year for individuals and married couples filing jointly. (It’s $1,500 for married individuals filing separately.) These losses can be used to offset any capital gains experienced in the same year. Moreover, losses that exceed $3,000 can be carried over and used in future years.

One of the conundrums of selling a losing investment is watching it go up right after you’ve sold it. And current tax rules prohibit investors who sell a stock or ETF for a loss from repurchasing the same investment or something identical within a 30-day period. If this rule is violated, the original trade is deemed a “wash sale,” and the tax loss cannot be used.

Bottom line: Exchange-traded funds make it easy for investors to avoid running afoul of the wash-sale rule, while helping investors avoid missing any future rebound.