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Getting a Tax Benefit from Capital Losses
Thomas Kosinski

As volatile as the stock market has been, you probably have some under-performing investments which have lost value that you are considering selling. Tax planning is especially important when you are considering selling at a loss. Why? Although you will be getting a potential tax benefit by reducing your taxes, locking in your losses will also lead to an economic loss when those investments bounce back after you sell. It is very important to consider both the tax and economic impact before you decide to sell under-performing investments.

The Short and Long of It

Capital losses — as well as capital gains — are reported in two categories:  Short term and long-term (referring to investments held up to one year or investments held longer than one year, respectively). Short-term gains are taxed the same as ordinary taxable income, and long-term gains generally are taxed at a federal maximum individual income tax rate – either 15% or 20% –depending on the overall taxable income in a tax year.

Capital gains and losses are calculated on a net basis. For example, if you have $5,000 of long-term gains and $7,000 in long-term losses (for a net loss of $2,000), as well as $3,000 in short-term gains and $5,000 in short-term losses (for another net loss of $2,000), you would have an overall net capital loss of $4,000.

You are allowed to use up to $3,000 in capital losses each year to offset your ordinary taxable income (such as from salary and interest). Married taxpayers filing separately must split this amount and each can claim up to $1,500 per year. So, the above example would allow you to claim a $3,000 loss against your taxable income in the same tax year as the losses, as well as save the remaining $1,000 to carry forward to future years.

Choose Carefully

Bear in mind that it may be difficult to determine which investments to sell at a loss. Selling investments that have declined the most in value relative to your purchase price will give you the biggest tax benefit. However, you will miss out on a potential recovery and the opportunity to add to your positions at favorable prices. One alternative is to buy back the stock after 30 days have passed. The IRS disallows losses under “wash sale rules” if you buy replacement stock within 30 days before or after the date of the sale because it assumes your only intention was to create tax losses.

It is important not to lose the tax deduction by replacing or buying “substantially identical investments” within 30 days of the original sale. A common way to meet this rule is to swap one type of investment for a similar performing investment. For example, you can sell shares in one mutual fund and buy shares in a fund managed by another provider, or sell one company’s stock and buy the stock of its competitor. This approach can help you to realize a loss while maintaining your exposure to a similar investment type.

If you opt to buy back the investment you sold after 30 days have passed, there is another risk — if the investment performs well in the interim you may miss appreciation in fair market value. Alternatively, you can purchase more of the same security and then sell 30 days later, but your exposure is that the price may decline further while you own twice as much.

Only Part of the Story

While tax losses provide you with a valuable tax-management tool, they are just one of many decisions and considerations to keep in mind. Your tax and investment advisors can help as you determine which purchases and sales will help you pursue your financial goals. Often these decisions are made at the end of the tax year when the tax benefits and the investment results are clearer. You should always consult your advisors so you understand your best options.

Always Check Your Cost Basis

To determine your capital losses, you need to keep track of your cost basis, which is the original price you paid for securities plus any commissions, reinvested capital gains or reinvested dividends.

When your entire investment in the security comes from a single purchase date, this is a relatively simple calculation. But if you buy the same security at various times or prices, or if you reinvested dividends or capital gains, the calculation can become more difficult. If this is the case, you may have to choose a specific method for reporting cost basis by:

  • Using the average purchase price;
  • Choosing specific shares (a more detailed approach that provides maximum flexibility but that must be identified when the shares are sold); or
  • Using the “first-in, first-out” method, in which the first shares you purchased are considered to be the first shares you sold.

Each approach will provide a different tax impact, so be sure to get qualified advice about which specific method is best for your personal situation.

For more information, contact Tom Kosinski at [email protected] or call him at 312.670.7444.

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