Admitting Investment Mistakes by Year-End Can Lessen Tax Burden

‘Tis the season to nip and tuck investment portfolios.

The last few weeks of the year are the savvy investor’s last chance to get tax mileage out of investment losses, experts note, but they also are a prime time to do investment planning.

“The tax clock is ticking,” said Duncan Richardson, chief equity investment officer at Eaton Vance in Boston. “It’s a natural human tendency not to want to admit our mistakes, but at this time of year you should at least consider taking advantage of what the tax code provides.”

The tax code lets people use their losses to offset investment gains and some ordinary income, but investors must “realize” those losses by selling the money-losing security. Too many investors fail to sell because they’re sure their investment will rise again, Richardson said. But if they’re careful, they can have the investment and the tax loss too.

How? Sell now and buy back later -- or buy something that’s similar but not “substantially identical,” suggests Philip J. Holthouse, partner in the tax law and accounting firm of Holthouse Carlin & Van Trigt in Santa Monica.

The process is tricky because of “wash” sale rules that are written into the tax code, Holthouse noted.

The rules are designed to prevent taxpayers from selling and repurchasing the same securities at the same price -- a wash.

The wash sale rules bar investors from claiming losses on the sale of a security if they have purchased the same or a substantially identical security within 31 days before or after that sale.

Those afraid that they’ll miss the stock’s run-up by waiting a month to repurchase the shares have another option: sell the money-losing stock and immediately buy something that’s similar.

An investor who owns ChevronTexaco Corp. shares, for example, could buy shares in Exxon Mobil Corp. Or that investor could sell his ChevronTexaco stock and buy shares in an index fund that tracks oil and energy stocks. Neither transaction would be a wash. However, selling ChevronTexaco stock and buying options in the company could be trouble. And in some cases, selling one share class of a company’s stock and buying another share class in the same company could be open to challenge.

Tax-inspired selling in a bond portfolio is even easier, Holthouse added, because both the maturity date and the yield can help distinguish one corporate bond from another. An investor could sell one IBM Corp. bond, for example, and buy another that matures a year or two later and pays a little more, without running afoul of Uncle Sam.

Trolling for losses is particularly profitable if investors have short-term capital gains, which are taxed at ordinary income tax rates that can run as high as 35%. (Long-term gains are taxed at 15%.) And stock losses can still be beneficial even for those who have no tax gains, because capital losses can be used to offset as much as $3,000 a year in ordinary income.

As long as investors are tinkering at year-end, they also should do two other things: rebalance their portfolios and take a hard look at where their money is invested, Richardson said.

Rebalancing is important because markets rarely move in lock step. Instead, one market may move up while another moves down. That can leave investors with far more stock or bonds than they had intended when they set up their investment plan, or over-invested in specialized categories such as international securities.

By taking a little off the top of their winning holdings and adding a bit to the losers, investors are taking advantage of age-old market wisdom of “buy low, sell high,” Richardson said. And they’re staying true to their investment plan, which can keep them out of a load of trouble in the end by spreading their eggs in different baskets.

Having the right investments in the right types of accounts also can save a bundle in future tax years and produce better overall returns, he said.

The reason: Bonds and real estate investment trusts throw off income that’s taxed at ordinary income tax rates

Stock dividends, on the other hand, are taxed at the 15% rate, as are profits earned on shares sold after a year. In addition, municipal bonds are now yielding 3% to 4% returns that are free of state and federal income tax.

Yet many investors put municipal bonds and stocks in tax-deferred retirement plans and put their bonds and REITs in taxable accounts.

That mixture can make sense for investors looking to pull income out of their accounts. But from a tax standpoint, it’s costly because the investor is deferring tax on assets subject to the 15% rate and paying tax on assets subject to the 35% rate.

Richardson suggests another tack that can provide income while still being tax smart: put dividend-paying stocks and municipal bonds in taxable accounts while stuffing taxable bonds and REITs in retirement plans. Naturally, if the bulk of an investor’s assets are in retirement accounts, he or she may want to have stocks in a 401(k) too.

But investors should steer away from having investments that throw off ordinary income in taxable accounts.

Investors who are selling partial holdings should review the rules on accounting for the profit, Holthouse said.

Consider an investor who bought 4,000 shares in a mythical XYZ Co. in 1,000-lot stakes over four years. The first group of 1,000 shares cost $10 each, or $10,000; the second group cost $12 each, or $12,000; the third group, $7 each, or $7,000; and the fourth, $15 each, or $15,000.

The stock is now at $14, and he wants to sell 1,000 shares.

If he simply placed a sell order for 1,000 shares, his broker would automatically unload the first shares he bought, netting him a $4,000 profit. But if the investor was looking to lighten his tax burden, he could designate the sale of the fourth lot -- allowing him to record a $1,000 capital loss.

“Anytime you are selling less than your full position in a company, it’s worth looking at those rules,” Holthouse said. “It’s very easy for you to send a note to your broker saying, ‘I want you to sell the shares that were purchased at this time at the highest price.’ ”

The only caution Holthouse adds for anyone considering tax-inspired selling is to remember that tax is only one consideration. The decision about what investments to hold should be about smart investing, not tax.

“There is a huge danger here, as there is in many areas of tax planning, where people get blinded by the tax savings and miss out on economic results that can completely trump the tax savings,” he said.

In other words, don’t let the tax tail wag the investment dog.

Kathy M. Kristof, author of “Investing 101” and “Taming the Tuition Tiger,” welcomes your comments and suggestions but regrets that she cannot respond individually to letters or phone calls. Write to Personal Finance, Business Section, Los Angeles Times, 202 W. 1st St., Los Angeles, CA 90012, or e-mail kathy.kristof @latimes.com. For past columns, visit latimes.com/kristof.