Accepting Loss on Your Investments Could Be a Capital Idea Right Now

Got a dog in your investment portfolio? This could be a good time to accept the drubbing on a bad investment and sell.

Congress is in the final throes of passing a tax overhaul that would dramatically change the rules related to recognizing capital gains and losses. The changes are by no means assured of becoming law: They still must clear a House-Senate conference committee, and President Clinton has threatened to veto the legislation unless significant changes are made.

But if the changes do happen, declaring your capital losses in 1995 would get you twice the tax bang for your lost buck than would be the case if you wait.

“Taking capital losses this year would be much better than waiting until 1996,” says Stephen R. Corrick, tax partner at the national accounting firm of Arthur Andersen & Co.

Here’s why: Congressional budget proposals call for drastically reducing capital gains taxes by making only half of the gains taxable. According to the proposals, you would net out your long-term capital gains and losses as usual. Should you have a net capital gain, you would divide the amount of the gain in half and then pay tax on that half at your ordinary income tax rate. So if your marginal tax rate is 28%, that means you’d pay 14% in federal income tax. If it’s 39.6%, you pay 19.8%.

Those rules, in current budget proposals, would go into effect retroactively in 1995, but some accountants speculate that the effective date could be pushed into 1996 before the bill becomes law.

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The proposals would also change the rules relating to capital losses starting in 1996. If the new rules go into effect and you have a net capital loss, you would only get to take half of it. Just as $6,000 in capital gains would only net you $3,000 in taxable income under the new law, $6,000 in capital losses would get you a deduction of just $3,000.

If you take the loss before the effective date in the law, the proposal says you would be grandfathered in under the old rules and could therefore deduct the full loss.

Tax change considerations aside, this still might be a good time to take a loss, simply to eat up gains likely to pop up in other areas of your portfolio, says Philip J. Holthouse, partner at Holthouse Carlin & Van Trigt in Los Angeles. Mutual funds, for example, are likely to pass through healthy gains thanks to the fact that the average equity fund posted a 27.2% return for the first nine months of 1995, according to Lipper Analytical Services in New York. Without a few losses to offset a few of those gains, you could be in for an unpleasant surprise at tax time.

What if you have no losses to report in your dazzling investment portfolio? Or you’re just trying to decide whether to sell now to lock in profits?

That’s harder to judge, experts say. The reason is that Congressional leaders currently have two effective dates for the proposed capital gains rules. One would make them retroactive to the beginning of January, 1995--so all gains recognized this year would be taxed at the lower rate. The other would make the changes effective in mid-October, so you’d have to calculate your taxable gains using two formulas--the higher rate for gains recognized early in the year; a lower rate for gains taken in the fall. However, tax experts think there’s an even chance that the capital gains tax cut would not actually go into effect until 1996.

If you are worried about the chance that your portfolio may head south before any capital gains changes fly, you have three options: Sell now and pay the piper; hedge, by selling short or buying a “put” option; or, if you have assets that are not publicly traded, you could enter into an installment sale.

If you sell short in this instance, you are essentially agreeing to sell your own securities at a set price at some point. The downside to this strategy is that you will not participate in the price gains if the value of your securities rises above the sales price. On the bright side, you’ll earn a nominal fee for selling the right to buy your shares in January.

If you buy a put, you buy the right to sell your shares at a set price in the future. But you are not obligated to do so. So if your shares soar in value, you keep them. You only exercise your put--selling out at the set price--if the price falls. The downside is that you pay for the put, and it can be relatively expensive.

However, if your gains are in residential real estate or in an asset that’s not publicly traded, you can sell without triggering today’s higher capital gains rates if you enter into an installment sale in which the first payments are due after Jan. 1, Holthouse says.

The best thing about installment sales is that the rules governing them are fairly liberal, Holthouse adds. You can, for example, require a bank letter of credit as security for the sale. As long as the first payment isn’t made until after January, the sale will be handled under 1996 capital gains rules.