Tax Advantage

Selling Losing Securities for a Tax Advantage :

Are you still holding on to that loser tech stock or mutual fund that you bought during the last bull market run? Or maybe you have a sentimental security that stopped making any significant appreciation since you purchased it. Well, from a tax standpoint, there might be no better time than the present to “dump that dog”. The tax advantages of setting your gains against your losses can be enormous as long as you follow all the rules and implement a few tricks of the trade.

Tax-loss harvesting, also commonly known as tax selling, is one of the ways to avoid taxes on some of your portfolio gains. Tax-loss harvesting is the selling of securities, usually at year-end, to realize portfolio losses, which an investor can use to offset capital gains and therefore lower personal tax liability.

Tax Treatment of Gains

If you, like many others, own shares of a mutual fund, you are most likely subjected to some type of year-end payout. This could be in the form of a dividend, interest payout, short-term capital gain or long-term capital gain. Now, if the security giving you the payout is in a taxable account, then Uncle Sam will be sure to want a piece of the pie come tax time.

For tax-reporting purposes, the short-term gains and losses (those made in one year or less) are first netted against each other for the tax year; then long-term gains and losses (those made in more than one year) are netted; and finally the remaining outcomes are combined together. So, a net short-term loss of $10,000 can be applied against a net long-term gain of $5,000 for a remaining short-term loss of $5,000 [-$10,000 + $5000 = -$5000]. In any given year, there is no limit on the amount of capital losses that can offset capital gains. However, only a maximum of $3,000 net loss can be deducted from ordinary income; any excess loss may be carried forward into future tax years. The carry-forward loss must maintain its definition as either a short- or long-term loss.

The Wash Sale

With the wash-sale rule, the IRS disallows a loss deduction from the sale of a security if a ‘substantially identical security’ (defined below) was purchased within 30 days before or after the sale. The wash-sale period is actually 61 days, consisting of the 30 days before and the 30 days after the date of the sale. For example, if you bought 100 shares of IBM on Dec 1 and then sold 100 shares of IBM on Dec 15 at a loss, the loss deduction would not be allowed. Similarly, selling IBM on Dec 15 and then buying it back on Jan 10 of the following year does not permit a deduction. The wash-sale rule is designed to prevent investors from making trades for the sole purpose of avoiding taxes.

Substantially Identical Securities

If you sell Intel stock and then buy Microsoft stock, you are not considered to be dealing in identical securities, and you would therefore not be subjected to the wash-sale rule. However, buying and selling Microsoft stock is considered dealing in substantially identical securities. If you purchase ABC Tech Fund and sell ABC Tech Fund, you’re dealing in identical securities.

Although selling and buying within the wash-sale period disallows the loss, this loss can be added to the cost of the new shares you bought, increasing your cost basis in the new shares.

Selling an S&P 500 index fund and then immediately buying an S&P 500 index fund from a different company is a shady area. Due to the IRS vagueness on wash sales and mutual-fund trading, you’ll likely encounter no issues with the deductibility of a loss resulting from this type of transaction. However, many tax professionals will advise to avoid the situation if possible.

Strategies

Here are some tax-savvy strategies and rules to keep in check when implementing tax-loss harvesting into your investment plan:

If you want to stay in the asset class, you can purchase a similar but not substantially identical security immediately after the tax-loss sale of your original position. Say, for example, you own 100 shares of the Vanguard Healthcare Fund. If you bought shares in the Putnam Health Sciences Fund, which is not equivalent to your Vanguard fund, you can sell your shares of Vanguard and realize a loss, but also stay invested in the same industry.

If after selling the security and realizing the capital loss you still believe that the security is a keeper, wait the 31 days for the wash-sale period to elapse, and then repurchase the original security.

Remember, there is no limit on the amount of capital losses that can be applied against capital gains. However, only a $3,000 loss can be applied against ordinary income in any given year. The remaining losses must be carried forward into future tax years.

If you and your spouse file separately, the maximum capital-loss deduction limit is $1,500 per spouse, not $3,000 each.
If a spouse dies, the loss may be deducted only on the final tax return of the deceased; his or her personal losses may not be carried over by the surviving spouse.

Conclusion

Tax-loss harvesting is the action of selling your losing securities to offset your taxable gains. Although tax-loss harvesting is a good way to reduce your tax liability, be sure to follow the wash-sale rule, which disallows deductions if you purchase the security within 30 days of selling it. It’s never too soon to start thinking about how the losses generated in your portfolio can offset the existing or year-end capital gains. Not only will you save money, but you’ll finally sell off that loser that’s been under-performing in your portfolio over the years.