Your Loss Can be Your Gain

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A capital loss occurs when you sell a security for less than your basis, which is generally the original purchase price, plus dividend reinvestment. Looking at their portfolio statements, many novice investors often panic at a list of losses. But, savvy investors who understand the tax laws see this as an opportunity to lower their tax liability.  With 2016 approaching its end, now is a good time to review your portfolio and begin your tax planning.

Calculate Long and Short-term Gains and Losses

A short-term investment is one that you’ve held for one year or less. A long-term investment is one that you’ve held for more than a year. You can use capital losses to offset any capital gains you realize in that same tax year, even if one is short-term and the other is long-term.  Here is an example of how it works:  this year, you decided to sell securities in your taxable account, resulting in a net short-term capital loss of $3,000 and net long-term capital gain of $5,000, you’ll pay tax on only $2,000 of long-term capital gain.  This provides a valuable benefit for you because you were able to realize the sales you wanted, lower your capital gains, and end up paying only the long-term capital gain tax rate.

Consider Tax Rates

For tax purposes, stock investments are considered either short-term or long-term. Realized gains on short-term holdings are taxed at your ordinary income tax rate, which can range from 10% to 39.6%. Long-term capital gains are taxed at a rate from 15% to 20%. This timing difference is significant, unless you are in the 10% to 15% federal income tax brackets, which qualifies you for the zero percent capital gain tax rate on the selling of long-term investment securities.  The zero percent capital gain rate provides valuable planning opportunities for both retirees, as well as higher income taxpayers.  “Retirees can avoid paying taxes on investments that have appreciated over the years, and high income taxpayers can gift (annual exclusion: $14,000, double to $28,000 if married to each donee) the appreciated stock to a lower earning adult child or grandchild, who might then be able to sell the stock and avoid the capital gains tax,” suggested Karen Wong, senior tax manager at Buchbinder.

Harvest Capital Losses to Save on Taxes

If there is still a loss after you net away your capital gains, you can deduct up to $3,000 ($1,500 for married people filing separately) from other taxable income such as wages, interest and dividends. Capital losses do not expire – they can be carried forward to future years until they’re used up. This is one of the best deductions available to investors.

Research and Replace

Keep in mind that the IRS, under the wash sale rule, disallows losses where an investor sells a security and then buys the same or a “substantially identical” security within 30 days of the sale. You have to wait 31 days to repurchase the same security you sold. But, you can simultaneously sell the stock you own at a loss, and buy the competitor’s stock with a different ticker symbol, thereby avoiding violation of the “same or substantially identical” provision of the wash sale rule.  At the same time, you just added to your portfolio a stock you believe has more potential or less risk.

Gain An Advantage

If you buy multiple shares of a security at different times, keep track of the dates and prices so you can decide which lot can be sold most advantageously. The IRS allows investors to choose among several methods of designating lots when selling securities and those methods sometimes produce drastically different results.  For example, you have shares of the same investment at different prices, you may be able to lower capital gains and minimize taxes by selling shares with a higher cost basis or long-term holdings, to lower the gain and pay the long-term capital tax rate.

Another tax strategy is if you buy mutual funds, pay attention to when the next capital gains distribution will occur and how large it will be. If the distribution is large and the date is imminent (they often occur in December), you might want to delay your purchase to avoid incurring a sizable tax liability. Bear in mind that prior dividends paid and reinvested in mutual funds you own were taxed, and therefore increase your tax basis in the fund.

End on a High Note

Stock prices fluctuate frequently, sometimes by shocking amounts in a single trading day.  We all want to profit from our investments, but given the volatility of the stock market, capital losses are nearly inevitable. However, capital loss deductions rules provide some relief for investors to recoup at least part of their losses on their tax returns. “It’s important to remember that, in terms of year-end tax planning, you can turn these losses into gains and potentially make a difference in your tax bill.  Nonetheless, you can still pop open that bottle of champagne!” added Karen.

© 2016

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