When Losses are a Good Thing

It's time for year-end tax management moves and there are a variety of strategies to consider this year, particularly with respect to the special treatment of Roth conversions in 2010, the potential expiration of the '01 and '03 tax cuts, not to mention the fact that the Estate Tax is coming back (and similarly, but more subtle in the implications, the Generation-Skipping tax).  And perhaps we'll have time to address them in another News and Notes article, but today's topic is about a tax management strategy which is useful almost every year: harvesting capital losses.

Before we can talk about harvesting losses, we need to talk briefly about capital gains, what they are, what they mean and how they are taxed.

Capital gains are (loosely) the profits one makes from selling a capital asset at a price greater than one paid for the asset.  In the context of most of our investment portfolios, this means that if you buy shares of stock or shares of a mutual fund, hold onto them for a while, then sell those shares for more than you paid, the difference is a capital gain, and usually it's taxable.  (Exceptions: if the asset is held in an IRA or 401(k), if the asset is your primary home, if the asset is real estate where you roll the proceeds into another piece of real estate, etc.  There are a variety of exceptions and the rules are sometimes quite complex.  But the general idea - you buy a mutual fund in your taxable brokerage account and later sell it - has widespread application.)

Capital gains are usually taxed, and in the United States, currently they are taxed at different rates depending upon (a) what your general tax bracket is and (b) whether the gains are short-term or long-term.  If your ordinary income tax rate is 25% or up (for singles, that means your taxable income is above $34,000 and for couples, above $68,000), long-term capital gains are taxed at 15%, and if you make less than that that tax rate on long-term capital gains is currently zero.

Capital gains are generally long-term if you've owned the asset for more than a year and short-term if you've owned the asset for less than a year.   Short-term capital gains are unfortunately taxed at your ordinary income tax rate (currently as high as 35%).

So what about losses?  If you have both long-term capital gains and long-term capital losses, you net them out by subtracting the losses from the gains and if the net is positive, you pay taxes at the long-term capital gains tax rate on the net.

Similarly, you net short-term gains and losses together and pay short-term capital gains taxes on the net if it, too, is positive.

And so what if after adding up all the gains and losses, you have net losses?  If, after adding up all your gains and losses, you end up with a negative number, you have net capital losses for the year.  Up to $3000 of those losses may be used as an additional deduction against ordinary income.  That's very valuable - if your marginal tax rate is high, say, 33%, then a $3000 capital loss will save you $1000 in income taxes!  And here's the kicker - if you have more than $3000 in capital losses, since you can't take all of those losses against ordinary income, you get to carry the rest forward and use those losses against next year's capital gains (and, if you still end up with net losses next year, take another $3000 against ordinary income next year).  These carried-forward losses never expire - you use them up a little at a time until they are gone, first against any capital gains and then up to $3000 against ordinary income.  Carried-forward capital losses are almost like money in the bank - they represent gains and income on which you won't pay in the future.

A nice thing about having harvested some capital losses and having them available is that when you have to rebalance a portfolio, you are going to want to sell things which have gone up and buy things which have gone down.  Rebalancing is an essential element of long-term portfolio management.  But if you are selling things which have gone up - you guessed it - you have to be aware of capital gains.  If you have capital losses available to offset those gains, it makes rebalancing much easier because you can reduce or even eliminate the tax consequences of the "sell high" part of "buy low, sell high".

So review your taxable portfolio.  If you have a investments which are worth less now than they were when you bought them, you should be considering selling them for the loss.  Don't believe that old notion that money isn't lost until you sell.  If an asset is worth less than you paid for it, you've lost money - you just aren't getting any tax benefit from that loss unless you sell.

There are a whole variety of twists to this - most of what's written above applies best to simple stock and mutual fund holdings in your taxable brokerage account, though capital gains issues also have impacts on sales of real estate, privately held businesses, collectibles, etc.  These latter types of property, however, are beyond the scope of this article - if you hold any of them, make sure to discuss your situation with an accountant, especially real estate which has had depreciation written down against it.

One more twist - if you sell, say, shares of stock for a loss and then buy back that same stock (or a "substantially identical asset") within 30 days, you do not get to keep that loss.  It's called a "wash sale".  The government doesn't want you harvesting losses too easily.  Note, though, that "substantially identical" still leaves a lot of room for "similar".  If you have losses in, say, an S&P 500 index fund, you can't just sell it and buy another S&P 500 index fund.  But you could sell the S&P 500 index fund and then buy another index mutual fund which holds large-cap US stocks as long as it tracks a different index, say the Russell 1000.  So don't worry about messing up your asset allocation by harvesting losses - if you sell something for a loss but need to keep your asset allocation where it was, you can almost always find something similar enough to keep your asset allocation intact, but different enough that you won't run into the wash sale rule.

The bottom line here is not to fret if you have losses in your taxable portfolio.  Over the long run, especially with equity investments, there will be years where things go down.  That's part of why we expect these more volatile investments to pay more in the long run, as compensation for the risk and volatility.  The best thing to do is use that volatility - and the losses that sometimes come with it - to your advantage.  Harvest those capital losses and use them to offset your ordinary income and to ease the process of rebalancing.  Losses are unfortunate, but there's an upside to them which is worth considering.

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