New Rules Add Incentive for Tax-Loss Selling

Get ready for a heavier-than-normal year-end rush of investors selling stocks and other assets to recognize losses for tax purposes, many experts say. Thanks to the poor stock market and new tax rules, many individuals and institutions have a greater incentive to engage in tax-loss selling this year.

Accordingly, if you have investment losers and want to take the losses, consider selling now before the crowd drives down the value of your investment even more.

Tax-loss selling is a good practice in any year if you have capital gains or ordinary income to shelter. Tax laws allow you to use capital losses to reduce capital gains dollar for dollar. If your capital losses exceed your gains, you can use up to $3,000 of the losses to shelter ordinary income from wages. You can carry forward any leftover capital losses to future years.

“If you have already taken some gains, and have losses in stocks that you are not particularly satisfied with, sell those losers and take those losses now,” advises William G. Brennan, partner with the accounting firm Ernst & Young in Washington.

This selling--along with further dumping by professional money managers seeking to “dress up” their portfolios for year-end reports--often drives down stock prices in late November and December.

But thanks to this year’s moribund stock and real estate markets, many more investors are likely to be holding losers. That, plus the gloomy outlook for many stocks and real estate, could prompt more year-end selling than usual.

“We’re in a very weak market, so obviously more people have losses,” says Kurt Brouwer, president of Brouwer & Janachowski, a San Francisco money management firm. Stocks most vulnerable to a selloff, he says, include issues that have already taken a heavy beating, such as banks, savings and loans, insurance and brokerage firms, retailers, telephone and technology firms, and small-company stocks in general.

New tax provisions enacted last week as part of the federal budget accord could prompt even more investors to sell.

For example, if you’re now in the 33% individual tax bracket--the so-called bubble--you may want to sell losers. That’s because your rate next year will fall to 31% or less; thus, your losses are more valuable this year because they will shelter capital gains or wages being taxed at a higher rate.

You may also want to sell winners if you are a very high income taxpayer now in the 28% bracket. Because the budget accord phases out exemptions and reduces deductions for wealthy taxpayers, you could end up paying a slightly higher capital gains rate next year. So you might want to take gains this year, particularly if you think those winners may turn into losers if you hold them much longer.

Yet another group that may want to sell now includes those who wanted to sell earlier but waited in hopes that Congress would lower capital gains rates. Since that bid failed, those people may be inclined to sell now.

What should you do?

First, don’t let taxes be your sole motivation for selling. The rise or fall in price of a stock or other investment can easily outweigh any tax benefit. Accordingly, base your decision primarily on your outlook for the investment.

“Now is a good time to ask yourself, would I buy this stock today at this price?” Brouwer says. “If the answer is ‘no,’ you should sell it.”

If you have mutual funds, you need not be as concerned about tax-loss selling, Brouwer adds. That’s because the fund’s portfolio manager usually takes care of selling losers in the portfolio to minimize your tax bite.

What if you have a loser but are optimistic that the stock may go up?

Consider selling it and then buying it back at least a month later. The “wash sale” rule prohibits you from recognizing a capital loss on a security that you sell and buy back within 30 days. But if you wait 31 days to buy back the same stock, who knows? You might get it cheaper if tax-loss selling is rampant.

What if you have a winner but think it will become a dog?

You can delay taking the capital gain until next year--when your tax rate might be lower--yet still lock in the profit now and protect yourself from further losses. How? By a technique known as “selling short against the box.” Under this method, you sell borrowed securities--what is called selling short--identical to the ones you own. Next year, you sell your original securities to close out your short position.

If you have appreciated real estate or other non-publicly traded assets, consider deferring the gain through an installment sale, suggests Sidney Kess, an accountant and tax attorney in New York. This way you can spread your gain over time.

In any event, if you have losses, “do it as soon as possible” to avoid the year-end rush, suggests Adrian Moravcsik, financial consultant with Bailard Biehl & Kaiser, a San Mateo, Calif., financial planning firm. His firm’s clients have already taken their losses, he says.

But selling is not the only option. If you have appreciated assets, consider donating them as a charitable contribution. This way you won’t be liable for the capital gains tax, and under most situations you can take a deduction for the value of the property. (But don’t do this if you have a loser. Instead, sell it and donate the proceeds; that way you get to report the capital loss.)

Another option to reduce capital gains is to give appreciated assets to your children, Brennan suggests. They can then sell the assets and be taxed at their presumably lower rate.

Finally, don’t just think in terms of selling. Price declines resulting from mass year-end dumping could result in good buying opportunities, Brouwer says.

“If you see a company or mutual fund you are following pushed down, this is going to be a good time to take some positions,” he says.