Your Investment Losses Might Have an Upside--Some Can Be Deducted

Tumbling markets and dot-com flameouts have one bright side: Investors have a chance to write off some of their pain at tax time.

Deducting investment losses isn’t always easy, though. And the tax-loss rules can’t be used by every investor.

For example, people who saw the value of their investments fall but didn’t sell their losers can’t take a deduction--unless the investments became worthless (more on that later).

There’s also no deduction for people who sold losing investments held within tax-deferred accounts such as 401(k) plans or individual retirement accounts. That shouldn’t be a surprise.

Gains in tax-deferred accounts aren’t taxed when they happen, so losses don’t exist for tax purposes either. Your money typically isn’t taxed until withdrawn from the account.

But for those who are eligible, the benefits of deducting losses can be great. Investment losses can be used to offset a comparable amount of investment gains, plus up to $3,000 of other income this year. Bigger losses can be used to offset gains in future years.

Here’s what investors need to know before tackling their tax returns:

Short or Long Term?

Your holding period--how long you owned the investment--is crucial in determining your tax bill.

The federal government gives a favorable tax rate to profits from investments that are held more than a year. The maximum federal tax rate on such long-term capital gains is 20%, whereas short-term capital gains--profits from investments held less than a year--are taxed at regular income tax rates of up to 39.6%. (California’s state income tax makes no distinction between regular income and capital gains; all income is taxed the same at rates of up to 9.3%.)

What constitutes long term? One year and a day, according to the IRS. The holding period starts the day after you buy the property and includes the day you sell it.

So if you bought a stock July 1, 1999, and sold it July 1, 2000, your investment is considered a short-term gain or loss. Sell it July 2 and it’s considered long-term.

Some short-term transactions can prevent you from claiming a loss, however. If you sold a stock or mutual fund at a loss but purchased a “substantially identical” security within 30 days of the loss sale--either before or after--you trigger the “wash sale” rules that prevent you from deducting the loss.

What does “substantially identical” mean? Obviously, you can’t buy and sell shares of the same company without triggering the wash sale rules. But you can sell Dell Computer Corp. and buy Apple Computer Inc. because they are different companies even if they’re in the same business.

The issue gets a bit muddier when dealing with mutual funds and bonds. Most actively managed mutual funds will be considered different enough, even if the one you sell and the one you buy are both, say, technology funds.

Questions have been raised when investors buy and sell index funds that mimic the same benchmark, however. And bonds from the same company can trigger the wash sale rules if they have the same interest rate--even if they have different issue dates and maturities.

Crunching Numbers

Once you’ve determined which investments are short-term and which are long-term, the IRS requires you to do some calculations.

First, you offset your short-term losses and gains against each other. You do the same thing with your long-term losses and gains.

Then you compare the results of these two sets of calculations. If your losses exceeded your gains, you owe no capital gains taxes. You can also use excess capital losses to offset as much as $3,000 in ordinary income, such as wages from your job. (Offset income isn’t subject to taxes; it’s as though you never earned it.)

Any loss over $3,000 can be “carried over” or applied to future tax returns until it’s used up.

As you can see, short-term losses are generally considered more valuable because they can be used to offset short-term gains--the type that are taxed at higher rates. It’s a good idea to keep all these calculations in mind whenever you’re faced with unloading a losing investment.

When It’s Worthless

Usually, investors have to sell a taxable security to claim a loss. The exception is investments whose value has fallen to zero--otherwise known as worthless securities.

Proving an investment is truly worthless can sometimes be tough. Stock of even bankrupt companies can continue to trade for a few pennies in obscure markets, such as the over-the-counter market or the pink sheets. Other companies simply fade away, never announcing that they’re going out of business.

Investors must show that a company is truly insolvent and no longer in operation to claim a deduction for a worthless security. One publication that can help is “Capital Changes Reporter,” a guide published by Commerce Clearing House that includes a section on worthless securities and lists companies that have gone out of business.

Investors can deduct a valueless security only in the year that it becomes worthless. Because the task is sometimes so difficult, investors often have to amend a past tax return to reflect when a company actually went out of business.

The rules on holding periods also are a little different. The loss of value is considered to have happened at the end of the year.

So shares of a company that went out of business June 30, 2000, could represent a long-term loss to someone who bought the stock just six months earlier, because the stock is considered to have become worthless on Dec. 31, 2000.