Tax Deductions Can Shield You From Some Capital Losses

Capital losses may be painful for investors, but they’re potentially helpful for taxpayers willing to harvest the losses for current and future tax deductions.

“The only thing good about bad markets is most of your [investment] sales aren’t taxable,” said Philip J. Holthouse, partner in Los Angeles tax law and accounting firm Holthouse Carlin & Van Trigt. “At least losses are deductible.”

There’s one caveat: Paper losses don’t count. To claim a capital loss on your tax return, you must have “realized” the loss by selling the investment for less than you paid. And if you have a loss within a tax-deferred account, such as a 401(k) plan, you generally can’t take advantage of it. Just as profits are sheltered from tax within these accounts, so are losses.

However, if the big declines in stock prices this year--and the large recent outflow of cash from stock mutual funds--are any indication, Americans are up to their elbows in realized capital losses. Here’s a primer on investment losses, when to trigger them and what to do with them.

* Triggering a loss:

To write off a capital loss, you must have realized the loss by selling the depreciated stock or fund.

For example, if you bought 100 shares of Cisco Systems at $65 a share ($6,500 total) and sold them for $10 ($1,000), you’d have a capital loss of $5,500.

That loss can be used to offset any 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.”

As with most things in the tax code, however, it’s not quite that simple.

To calculate your net capital gains or losses, you first must group the securities according to how long you owned them. If you held a security for a year or less before selling it, it’s classified as a short-term loss or gain. If you held it for more than a year, it goes in the long-term category.

On Schedule D of your federal 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, leftover losses can be used to offset gains of the other type, if you have any.

This is a crucial exercise, because long- and short-term gains are taxed at different rates. Long-term capital gains are taxed at a 20% rate, while short-term gains are taxed at ordinary income tax rates, which can exceed 38%.

Here’s how the math works: Suppose you sell your holdings of stock A, realizing a short-term gain of $1,000. You also own shares of stock B, which you bought for $3,000 but which are now worth $2,000. By selling stock B, you generate a loss that completely offsets the short-term gain from selling stock A. And since short-term gains are taxed at regular income tax rates, that would save someone in the 31% bracket $310 in federal income taxes.

A caveat: It’s not always advisable to sell an investment simply to generate a tax loss. Generally you should have other reasons for wanting to sell the security--for instance, conditions in its industry have changed and you no longer think a company is a good long-term investment.

* Wash sales:

One reason you should carefully consider whether to sell a security is that so-called wash sale rules prohibit you from selling a stock to trigger a loss and then immediately repurchasing it. You must wait at least 31 days to repurchase the same security. If you purchase an identical security before that point, you’ll trigger the wash sale rules, which effectively wipe away the capital loss.

What if you’re a mutual fund investor and you want to sell one fund and buy another that’s similar? If you purchased the identical fund, you would trigger wash sale rules, but you probably could buy another fund--even another fund that was similar to the one you just sold--without triggering a wash sale, as long as there was some difference that mattered.

For instance, you could sell one growth fund and buy another--assuming the funds had different managers and didn’t own all of the same stocks. In some circumstances, you might even be able to justify buying a fund that had substantially the same investments.

For instance, you might sell XYZ Corp.’s S&P; 500 index fund and buy ABC Corp.’s S&P; 500 index fund if you could point to some compelling difference between the two. Such as? If ABC Corp. charged lower annual management fees on its fund; if you had other accounts with ABC and wanted to consolidate your holdings to one fund company; or if ABC could be traded on the Web, while XYZ could not, those would all be differences worth trading a security over.

* Reduce ordinary income:

If your total realized losses exceed your gains in any one year, you can use up to $3,000 in excess capital losses to reduce the amount of ordinary income (such as wages, dividends and interest) subject to tax. This loss is reported on line 13 of the 1040 tax form. Instead of showing a taxable capital gain there, you’d put the amount of the loss--up to $3,000--in brackets.

Since ordinary income tax rates can exceed 38%, a $3,000 deduction against ordinary income is particularly valuable. It can save a high-income taxpayer roughly $1,140 in federal taxes each year versus the $600 you’d save if that loss was used to simply offset capital gains that would have been taxed at lower rates.

* Carry losses forward to reduce future capital gains and income:

Say you’ve offset all your capital gains, have $3,000 in losses to offset ordinary income, and you still have losses left over. Now what? Capital losses can be carried forward to offset future capital gains--plus as much as $3,000 in ordinary income each year--until they’re used up, or you die, whichever comes first, Holthouse said.

Lawmakers have been debating proposals that would raise the maximum amount that taxpayers could write off against ordinary income to as much as $20,000 annually, said Brenda Schafer, senior tax research coordinator with H&R; Block in Kansas City, Mo.

“It’s not clear right now whether this legislation is going anywhere,” Schafer said. “But you wouldn’t want to be in a big hurry to trigger a gain to use up capital losses. If they do change that limitation, you’d be wishing you hadn’t done that.”

* Special rules for funds:

If you invest primarily through mutual funds, there are a two important tax-related issues to keep in mind.

First, although funds are required to distribute annual realized capital gains to shareholders, they aren’t allowed to distribute capital losses. If your fund, like most, is down for the year, the only way to realize that loss is to sell the fund.

Second, remember that determining your net gain or loss on a fund you’ve owned for several years usually isn’t as simple as comparing the amount of money you invested in the fund with what it’s worth now. In years when your fund made money, you probably received a capital gains distribution from the fund and paid tax on it. If you’ve held a fund for several years, you probably have already paid taxes on a large chunk of the gains you may realize when you sell the fund.

* Consider the “deemed sale” election:

There’s a little known “election” that taxpayers can make until Oct. 15 of this year. It essentially allows you to pretend to sell a stock that you hold at a gain; pay the tax on the gain; and then start the clock running on the holding period again. Why would you do that? Because if you hold the asset for five years after the so-called deemed sale, you would reduce the maximum capital gain tax on that asset to 18% from 20%. In other words, for every $1,000 in gains earned on that stock after the deemed sale, you would save $20 in federal tax.

Deemed sales cannot be used to trigger a loss, tax officials say. The option is a one-time-only election that was created five years ago in an obscure capital gains law that provided lower capital gains tax rates for long-held assets. Because the new rate applied only to assets acquired after Jan. 1, 2001, legislators wanted to give people who had held stocks for decades the chance to get this lower rate on stock they continued to own. Thus, they created the deemed sale election.

Still, unless you have such huge capital losses that you’re certain you couldn’t use them up in your lifetime, it doesn’t make a lot of sense to trigger a gain to offset a capital loss that might come in handy later, Holthouse said.

On this issue, and others, it might be best to consult a tax advisor.