Year’s Market Losses Can Provide Tax Relief

Forget capital gains. This year, most investors have losses, and lots of them.

That makes this a perfect time to do some tax planning to see if your investment losses can at least save you a little money on your 2001 federal income tax bill.

Naturally, taxes shouldn’t be the primary consideration when weighing whether to buy or sell a particular investment, such as a mutual fund. However, factoring taxes into the equation is wise, financial advisors say.

“As long as you are always weighing the pure investment decision as well as the transaction costs, it is a good strategy to try to harvest some losses while you have them,” says Philip J. Holthouse, partner with the Los Angeles tax law and accounting firm of Holthouse Carlin & Van Trigt.

“If you can use losses that you were going to take anyway to shelter gains, that’s worthwhile,” he said.

For those who haven’t had to cope with investment losses for a while, it might be helpful to review the basics:

Q: What is a capital loss?

A: It is a realized loss on the sale of securities, such as stocks or stock mutual funds, that aren’t held inside a tax-favored retirement account.

For example, if you bought 10 shares of Yahoo Inc. at $245 each (or $2,450 total) and sold them for $10 ($100), you would have a $2,350 capital loss.

That loss can be used to offset capital gains--realized profits--from the sale of other investments during the year, including capital gains paid out by mutual funds in their annual “distributions.”

And if your total realized losses exceed your gains--a likely scenario this year for many people--you can use up to $3,000 in excess capital losses to reduce the amount of ordinary income (such as from wages, interest or dividends) that is subject to tax.

Q: What happens if I have a capital loss within a tax-favored retirement account?

A: From a tax standpoint, losses in these accounts can’t help you. Just as gains realized within a retirement account aren’t taxed as they occur, you don’t get to write off realized losses.

Q: How do I calculate my tax bill when I have both realized gains and losses?

A: To calculate net capital gains or losses, investors first must group the securities they sold according to how long they owned them. If you held a security for a year or less before it was sold, it falls in the short-term category; if you held it for more than a year, it’s a long-term gain or loss.

On federal Schedule D of your tax return, you first offset long-term losses against long-term gains and short-term losses against short-term gains. If you have more losses in either the short-or long-term category than gains in that category, remaining losses can be used to offset the other type of gain, if any.

Q: What’s the point of dividing up short-and long-term gains and losses?

A: Short-term gains are taxed at higher rates than long-term gains.

If you have more gains than losses, you would pay tax on net long-term gains at a maximum 20% rate, while net short-term gains would be taxed at your ordinary income tax rate.

Thus, if you have a lot of short-term gains, capital losses become particularly valuable because they’re offsetting profits that could be taxed at rates as high as 39.6%, the top ordinary tax rate.

Q: Should I sell a stock or mutual fund that I’m holding at a loss, so I can offset gains I may have in other investments?

A: Perhaps--if you have already decided you don’t want to keep that particular stock or fund for the long haul anyway.

Consider this example: You sell your holdings in ABC Co. and realize a short-term gain of $1,000. You also own $2,000 worth of XYZ Corp. stock that you bought for $3,000. You sell the XYZ shares, triggering a $1,000 loss that you can use to offset your short-term gain in ABC. Assuming you’re in the 31% federal tax bracket, that transaction saves you $310 in taxes.

But if you still like XYZ as a long-term investment, selling just to take your current loss ultimately could be more costly, if the stock rebounds.

Q: If I have a loss on a stock that I still like as a long-term investment, why can’t I just sell to take the loss, then immediately buy back the stock?

A: The IRS doesn’t allow that. Under the agency’s “wash sale” rules, if you buy a stock within 31 days of selling the same or a “substantially identical” security at a loss--that’s 31 days before or after the sale--the IRS will disallow your loss, rendering it useless for tax purposes.

Q: Could I sell a stock and immediately buy an option contract to buy the stock at the same price in the future?

A: No. An option to buy the same stock would fall under the “substantially identical” umbrella as defined by the IRS, making your transaction a wash sale unless you wait the required 31 days.

Q: What if I invest through mutual funds: Could I sell one growth-stock fund and buy another without running afoul of the wash-sale rules?

A: Most likely, yes. As long as the fund you sold doesn’t own substantially the same securities as the one you sold, isn’t managed by the same person, and doesn’t charge the same management fees, you’re on solid ground, tax advisors say. This would not be a wash sale.

Q: What if I sell a Standard & Poor’s 500 index stock fund and buy another S&P; index fund?

A: This is shakier ground because both funds are likely to own the same stocks and the fund manager isn’t much of a factor in the fund’s performance. But you may be able to justify the transaction if you were switching funds to get the benefit of a lower annual management fee, experts say.

Q: How do I use a capital loss to offset ordinary income?

A: If you find that you have more losses than gains in any given year, you carry the net loss from Schedule D to line 13 of the 1040 tax form.

Up to $3,000 in losses can be used to offset your regular income in any given year. If you’re in the 31% bracket, that could save you as much as $930 in federal income tax.

Q: What if I have more than $3,000 in left-over losses?

A: You can carry them forward for use in future tax years. However, when you record losses in a future year, you’ll again have to first use them to offset any capital gains before applying any balance to reduce ordinary income up to $3,000.

Q: I invest primarily through mutual funds. I know that funds must distribute (pay out) all realized gains each year to shareholders. But what happens when funds have net realized losses? Do funds “distribute” losses?

A: No. Under federal law funds must distribute realized gains they record in trading stocks each year. But the funds aren’t permitted to distribute losses. Shareholders can’t record losses on mutual funds unless they actually sell the funds at a loss.

Fund investors also can face a challenge determining whether they have a taxable gain or loss on a fund they’ve owned long term.

Because funds pay out realized gains each year, shareholders are taxed on those gains as they receive them. A fund’s net asset value per share is adjusted downward to account for each capital-gains distribution. So the good news is, when you sell a fund you’ve held for years, you may not have a large taxable capital gain on the shares, even if the fund’s performance has been stellar.

Q: When I get my capital-gains distribution notice from my funds, they never report short-term gains--only long-term gains and ordinary income. I think the ordinary-income category includes both short-term gains and dividends. Can I get the fund company to report the short-term gains separately?

A: No. Tax law requires mutual funds to lump short-term gains with interest and dividend income. The funds aren’t allowed to break out these gains so you can use them to specifically offset short-term capital losses.

Q: I bought stock in a start-up company and lost a bundle. The shares are now worthless. Is there any way to write off more than $3,000 a year against my ordinary income?

A: If you lose money on an investment in a so-called 1244 company--that’s a small domestic corporation that had less than $1 million in equity when it issued stock--up to $50,000 in losses for singles or $100,000 in losses for married investors can be “converted” from capital losses into ordinary losses.

That means losses on this type of stock do not have to be used to offset capital gains. They can be directly deducted from your wage and salary income, which is taxed at a significantly higher rate than investment gains. “It’s a very narrow exclusion,” says Holthouse. “But, if you happen to satisfy the rules, it’s a big win.”

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Kathy M. Kristof can be reached at kathy.kristof@latimes.com.