Great Crash Losses May Become Tax Gains
Depressed that your stocks tumbled in the Great Crash? Bummed because your bonds lost value this year? Miffed that your mutual fund is a dog?
All is not entirely bad. Your losses on those investments could provide you with a nice tax break.
That’s because Uncle Sam lets you use capital losses to offset capital gains dollar for dollar--in effect, allowing you to earn those gains tax free. You can use any excess losses above gains to reduce your taxable income from wages and salaries by up to $3,000 per year. Unused losses can be carried forward into other years indefinitely, to offset future income or capital gains.
So, even if some of your investments are lemons, “you can still make lemonade out of them,” said Judith R. Samuels, manager of the tax advisory department of Thomson McKinnon Securities. “You might as well take advantage of a situation you didn’t want to be in.”
The key is to make sure you don’t waste your paper losses. If you have gains you have already taken, now might be a good time to sell a loser. If you have already taken losses, now might be a good time to sell a winner.
Such matching of losses and gains doesn’t have to be limited to stocks, bonds or mutual funds. It can also include your home or other real estate, art or other collectibles, precious gems or metals, even certain pension plan gains--anything that qualifies for capital gains treatment, said Sidney Kess, partner at the accounting firm of Peat Marwick Main.
Taking advantage of matching such losses and gains also can be an opportunity to restructure your investments, by selling off losers and putting your money into investments that you think will be winners.
How does it work? Let’s say you lost $6,000 on a stock but have a profit of $2,000 on another. If you sell both loser and winner, you can use $2,000 of the loss to offset the $2,000 profit, making the profit tax free. You can then use $3,000 of the remaining loss to reduce your regular taxable income by $3,000. (If you are in the top 38.5% bracket this year, that would save you $1,155.) You can then carry the remaining $1,000 of losses into next year.
(Technically, this year, you must first offset all short-term gains against all short-term losses, and all long-term gains against all long-term losses, before you can mix and match long-term and short-term gains and losses. But most investors probably don’t have complicated enough situations to worry about any mismatches.)
Here are some tips for making use of capital losses and gains:
- Consider whether it makes economic sense to sell your investments solely for tax purposes. Any additional profits, or reduction in your loss, from holding an investment could easily outweigh tax savings from selling now. Sales commissions or other transaction costs also could far outweigh tax savings.
“You should look at the economics first and foremost,” said William Oberman, a vice president at Bailard, Biehl & Kaiser, a financial planning firm based in San Mateo. If your losses or gains on an investment are only a small fraction of its total value, “the chances are that market moves can overwhelm the tax considerations by far.”
- Determine your tax bracket this year and next. That will help you decide whether it is advantageous to realize capital losses and gains this year or next.
Tax reform has made matching of gains and losses more advantageous this year, under certain conditions. Taxes on short-term capital gains (held less than six months) and ordinary income will fall from a top rate of 38.5% this year to 33% next year. Thus, you may want to use losses to offset short-term gains or ordinary income this year, since they otherwise would be taxed at a higher rate.
However, if your tax rate will be higher next year (which might be the case if you are subject to the 21% alternative minimum tax this year but not next), you might want to “save” losses until next year and let ordinary income or already realized capital gains be taxed this year at a lower rate. That could be a good strategy if your losses are small compared to your gains, and you expect gains next year.
- If you want to claim a loss on an investment but still think it may go back up in value, consider “swapping” it for something similar. Unfortunately, due to the “wash-sale” rule, the Internal Revenue Service forbids you from claiming losses on securities if you buy the same, or virtually the same, securities within 30 days of the sale. This is to prevent you from selling a stock, and then repurchasing it, merely to claim a loss.
However, if you don’t want to wait 30 days, you can get around this rule by swapping for a different investment with virtually the same characteristics. For example, you can sell Exxon stock and buy another oil issue, such as Mobil. Or you can sell Fidelity Magellan, an aggressive growth stock mutual fund, and buy another one such as Fidelity Freedom. Many brokers, financial planners and other experts can help arrange such bond, stock and mutual fund swaps.
But be careful on record keeping. The IRS has strict rules governing sales of securities for tax purposes. If you bought shares of the same company at different times and prices, be sure that your broker specifically identifies on your confirmation statement which shares you are selling, Thomson McKinnon’s Samuels said. Otherwise, the IRS assumes you are selling the first shares you bought, she said.
- If you need capital gains to offset against your losses, consider selling a winner but buying it right back. You can do this because the wash-sale rule only applies to capital losses, not gains.
This way you enjoy the profit tax-free while still giving yourself a chance to earn even more. Also, you establish a higher initial price, or “basis,” for the investment. That in effect means any new gains on the investment will be lower for tax purposes.
- Do a “trial run” on paper to estimate the tax and investment consequences of capital asset sales. You still have time, since you can sell assets as late as Dec. 31 this year to have it count on your 1987 returns.
