Advertisement

# Short-Term Gain Better Than None

Share
<i> Debra Whitefield cannot answer mail individually but will respond in this column to financial questions of general interest. Do not telephone. Write to Money Talk, Los Angeles Times, 780 Third Ave., Suite 3801, New York, N.Y. 10017. </i>

QUESTION: I am a newcomer to the stock market. At first, I did amazingly well, doubling my money in just a few weeks. But my record over the past two months has been lousy. I’m doing this just for the fun and challenge of it, so I really have no interest in getting a broker’s help. But I’m getting a little worried and am thinking about selling off some of my stock even though I haven’t owned it long enough to qualify for the tax break given long-term gains. Is there any way to figure out pretty accurately how long to hold on before the tax break is worth less than the loss from falling stock prices?--S. O.

ANSWER: There is a pretty simple formula. It requires that you know your tax bracket, the amount you paid for your stock and the current value of your holdings.

First, you must determine what your profit would be if you sold the stock now.

Advertisement

Then, calculate what percentage of that you would keep if the entire profit was taxed. Obviously, if you are in the 50% tax bracket and your entire profit is taxed, you keep 50% of it.

Third, figure what percentage of the profit you would keep if only 40% of it was taxed. Again, if you are in the 50% tax bracket, only 20% of the profit would be lost to taxes and you would keep 80% of the gain.

Why use 40%? Only 40% of a long-term capital gain is taxable, compared to all of a short-term capital gain. In this case, long term means at least six months after the day you buy the stock.

When you have all of those numbers, divide your after-tax percentage return on the short-term gain by the after-tax percentage return on the long-term gain. Then multiply the resulting percentage by the amount of the short-term gain.

The result is your price floor. Once the stock price dips below that number, you lose out. At that point, your pocketbook would be better off if you sold your stock and paid the higher taxes.

Gobbledygook to you? Let’s try an example.

Say you bought \$5,000 worth of stock on Jan. 29. You would have two months remaining before the six-month waiting period kicks in, cutting your maximum tax bill to 20% instead of 50% of your profit. Should you wait and risk the stock price dropping so dramatically that it eats up all of the tax advantage and then some?

Let’s say your stock is worth \$6,000 right now. So, you would make a profit of \$1,000 if you sold it today.

Let’s also assume, just to make the calculation easy, that you are in the 50% tax bracket. Taking your profit now as a short-term gain means that you would pocket \$500 after you pay the taxes, or 50%.

Were you to wait two more months to get the more advantageous long-term capital gain treatment, that same \$1,000 profit would be worth \$800 to you, since only 40% of the profit would be taxable. In your bracket, half of that would go to the government, leaving you with \$800, or 80% of the profit, to spend.

So how much further can your stock holdings deteriorate before you lose the advantage of waiting for the tax break? Divide 50% by 80%. You should get 62.5%.

Next, multiply 62.5% by your current profit--\$1,000. The result: \$625. So, unless your stock holdings drop below \$5,625, giving you a profit of less than \$625, you are better off holding onto the stock and waiting until July 29, the end of the six-month holding period.

On a long-term gain of \$625, you would have to pay Uncle Sam \$125 in your tax bracket. So, you would pocket \$500, the same amount you would now if your entire profit were taxed at 50%.

Q: I am desperately in need of some tax deductions to reduce my federal income tax bill and have been having a difficult time finding investments that fill the bill but aren’t terribly risky. One thing I am considering is investing in a limited partnership. I’ve been trying to read up on them and keep running across something called at-risk rules. But they’re never explained. What is this and is it something I should worry about?--G. C.

A: At-risk rules limit the deductions that an investor in a limited partnership can claim. They are called that because the investor can claim deductions only to the extent that he or she is actually “at risk” in the venture.

If you put up 10% of the cash, for example, then you are entitled to 10% of the losses because you have put that much at risk.

The at-risk rules become a bit tricky and a cause for worry when a loss arises through circumstances where it isn’t absolutely obvious to the Internal Revenue Service that the investors were personally liable for the loss. Most notable is the case where the limited partnership borrows money and the individual investors claim deductions for losses arising from the venture that those borrowed funds paid for.

Say you invest in a limited partnership that borrows money to buy the California franchise rights to a popular imported ice cream. But the business doesn’t do well here. The limited partnership loses hundreds of thousands of dollars, and the individual investors try to claim deductions for their share of those losses.

The IRS very likely would question the deductions, citing the at-risk rule that says borrowed funds only increase the amount that an investor has at risk if he or she is personally liable for repaying the loan.

To get such a deduction, you would have to convince the IRS that you were economically at risk for all or part of that loan. Not an easy task, particularly as the IRS has tried to crack down on tax shelters promising huge writeoffs. There are even some cases where the limited partners signed agreements with the lenders holding each partner personally liable for his or her share of the loan and the IRS still denied the deductions.

Advertisement