Tax-Loss Selling
Selling stock for a loss is never any fun, but the loss can come in handy at tax time. Using your losses to offset capital gains or earned income eases the pain a bit. By carefully timing the sale of stocks that are losing money, you can maximize the loss' tax-saving potential.
By Ann Coleman (TMF AnnC)
November 10, 2000
There's nothing good about losing money. You hear a lot about tax-loss selling and how it can save you money on your income taxes, but basically that's making rather weak lemonade from the situation.
Still, when a year like this one comes along, tax savings might be the only bright spot in a sea of red. With a bit of planning, you can make the most of those savings.
As I hope you know, you must report the sale of all stock that is held in taxable accounts on Schedule D of your income tax form. (Just for the record, your broker reports those sales to the IRS, too.) Sales of stock held for one year or less are reported in the short-term capital gains and losses area, and sales of stock held for longer than one year are reported separately in the long-term capital gains or losses area. This is because short-term gains are taxed at your regular income tax rate (15%, 28%, 31%, 36%, or 39.6%), while long-term gains are taxed at 10% if you are in the 15% category for regular income, or 20% for all other tax brackets.
Capital losses can be more valuable than you might think just from looking at those tax rates. That's because, under the right circumstances, long-term losses can be used to offset money that would be taxed at your highest rate. Here's how it works:
Schedule D has you first consolidate gains and losses from all short-term transactions to get a net short-term capital gain or loss. Then you consolidate gains and losses from all long-term transactions to get a net long-term capital gain or loss.
Then, short-term losses are used to offset any long-term gains, or vice versa. All of this happens before the tax rates come into play, but one interesting thing is that if you have long-term losses "left over" after you offset all of your long-term gains, they are used to offset short-term gains or ordinary income.
When long-term losses are used to offset short-term gains or your ordinary income, they become more valuable than you might think. A long-term transaction that would ordinarily be taxed at 20% if it were a gain, can be used to offset income that would ordinarily be taxed at 28%, 31%, etc., when it is a loss.
Say you have a stock that's way down and you don't expect a recovery, so you are planning to sell it and turn your paper loss into a realized loss. The timing of the sale has "major tax implications" as the accountants like to say. If you realize your loss in a year where you have equal or greater long-term gains, your loss will be used to offset those gains, reducing the gain on which you will be paying a 20% tax. But if you can time your sale for a year in which you have fewer or no long-term gains, then the long-term loss will be used to offset either short-term gains or ordinary income, both of which are taxed at a higher rate.
Here's an example: Assume you are in the 28% tax bracket. If you time a sale so that you end up with a net long-term loss of $3,000 (the maximum you can claim in any one year -- any excess carries forward), the $3000 loss reduces your adjusted gross income by $3000, saving you $840 (28% of $3,000). If used to offset long-term gains, the tax savings would have been only $600 (20% of $3000). If you are in a higher tax bracket, the savings are even greater. In the highest tax bracket, a net loss of $3,000 amounts to a tax savings of $1,188 when used to offset your income or short-term gains, versus $600 when used against long-term gains.
So, while no one likes losses, most people understand that they are inevitable when investing. Timing the realization of a net long-term loss in a year where you have only short-term gains or ordinary income to match it against can make the loss less painful. If you have short-term and long-term gains, careful timing of your trades can maximize the power of those inevitable losses. The first example below shows how.
For mechanical investors, there are two issues when it comes to tax-loss selling: first, making the most of stocks that you would normally sell as part of your current rotation. For example, if I had renewed the Foolish Four Portfolio around 2:00 p.m. yesterday, I would have sold J.P. Morgan <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: JPM)") else Response.Write("(NYSE: JPM)") end if %> for a gain of $484, and General Motors <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: GM)") else Response.Write("(NYSE: GM)") end if %> for a loss of $287.
Let's pretend that I've held both stocks for more than one year and that the account isn't an IRA. The tax on J.P. Morgan's gain would be 20% of $484, or $97. But, that $484 capital gain would be offset by a capital loss on GM of $287, so the actual tax would be calculated on the difference between the two, or $197. This means I would only pay $39 (20% of $197), a tax savings of $58.
Suppose I knew I was going to be reporting a short-term gain of at least $484 as well. If I had sold GM a day early, my loss of $287 would go in the short-term area and would offset the short-term gain. I'm in the 28% tax bracket, so the tax on a short-term gain of $484 would have been $136. By offsetting it with the sale of GM, I've reduced that tax to $55 (28% of $197) for a savings of $81. That's a 40% greater tax savings than if I had used GM against the long-term gain. (In the highest tax bracket, this trick would have saved someone $113, a 94% increase in tax savings.)
By putting your losses in the short-term column, when possible, you leverage their tax-saving power. When you go to sell, check your calendar. If you are near the one-year mark, move your losses to the short side of one year and your gains to the long side.
The second issue is: What about stocks that are down now, but that you intend to keep? If it weren't for the wash sale rule, you could sell them now, buy them back immediately, and claim the loss on this year's tax return. Alas, the wash sale rule put the kibosh on that. If you repurchase a stock within 30 days of the sale (or, for that matter, buy it 30 days in advance of the sale), the sale is considered a "wash" for tax purposes. No loss is recognized. Darn.
You could, of course, sell now and buy the stocks back after 30 days. But what if the price goes up between now and then? You would get your loss for this year, but reduce your potential profit if you have to buy back at a higher price. That's the reason why we don't recommend tax-loss selling of stocks you intend to hold. It sounds slick to sell for a loss and buy back later, but if you've chosen your stocks carefully, you are more likely to find that they jump while you're out of them. Ouch.
I have to say it, though. Right now we may be seeing a window of opportunity for this particular situation. Normally, one would expect something of an after-election-day rally in the markets, as uncertainty is removed. However, if the doubt about who won the election goes on for more than a month, and I can't see it being resolved without a court challenge from both sides, the markets are not likely to do anything at all nice between now and the time we have a solid winner. The market hates uncertainty, and this is about as uncertain as politics can get.
If I were looking at some nice short-term losses, I would be very tempted to take the losses and run the risk that they might go up while I waited out the wash sale rule. Just this once.
Having gone way out on a limb making that prediction, I will undoubtedly be proven wrong, and the markets will surge over the next month as we all wait to hear who the next president will be. OK. I can live with that.
Stay tuned: On Monday, I will cover the three most frequently asked questions about investment tax issues.
Fool on and prosper!
