|
Tax
Loss Harvesting
by: James
Lange, CPA, JD
December 2003
Appropriate
tax planning can’t restore your losses, but it can reduce
or eliminate the tax on your winners. Using losses to reduce taxable
gains by means of tax-savvy realization of losses to match gains
is referred to as loss harvesting or tax-loss selling. For many
readers, tax loss harvesting is the single most important area for
reducing taxes now and in the future. Financial planners and advisors
who understand and apply these principles really do offer “value
added service.” Proper tax loss harvesting strategies can
save you taxes and help you diversify your portfolio in ways you
may not have considered. Now is the time to start thinking about
harvesting losses to offset unrealized capital gains.
Example:
Assume you have
a winner; you bought it for $50, it is now worth $100 and there
is no adjustment to the basis.
Also, please
assume, you have a loser; you bought it for $100 and now it is worth
$50. What are your options?
Lets assume
you are in the 25% tax rate table for federal purposes and both
transactions qualify as a long-term sale.
Idea 1: Buy
and Hold
Do nothing,
buy and hold. No taxes on any transaction. Next year, if you sell
the winner, perhaps in a rebalancing or diversification attempt,
and hold on to the loser, you will have to pay $7.50 in capital
gains tax ($50 x 15% tax = $7.50 tax).
Idea 2: Dump
the Loser
Sell the loser
and deduct $50 in losses. This means you will pay $12.50 less in
taxes than you would have if you had done nothing (Idea 1). Knowing
that you will pay $12.50 less in taxes (the 25% of your losses that
you can deduct), you can afford to reinvest $62.50 (the $50 sale
price of the investment plus the $12.50 tax savings; subject to
limitations), which is 25% more than your losing investment was
worth ($62.50 is 25% more than $50). So, you get an immediate $12.50
benefit. When you add state capital gains taxes, the savings are
greater.
If you later
sell the winner for $100 and have to pay capital gains tax of $7.50
($50 x 15%), at least you enjoyed the time value of your $12.50
while you held the stock. If you can use other losses to offset
the winner, you would be $12.50 ahead plus the growth on the $12.50
over time.
Idea 3: Dump
the Loser and Repurchase
Let’s
assume you like the loser or it is a “core holding”
of your portfolio or you think the loser will come back. Sell the
loser and then, subject to the wash rules, buy it, or something
similar to it, back. Assume you made the correct decision to sell
and repurchase. After repurchasing the loser for $50, its value
climbs back to $100. Except for transactions fees, you would have
the benefit of the $12.50 savings you made by deducting the loss,
and you have the growth. Furthermore, you have maintained the integrity
of your portfolio.
Idea 4: Use
Your Losses to Diversify Your Portfolio
Let’s
assume you have a heavy position in a particular stock or mutual
fund in a particular sector (like a large cap fund) that has a low
basis. You have avoided selling it for years because you are too
cheap to pay the capital gains tax. (Let’s be honest here.)
Then, either your advisor nags you or the fear of an Enron scenario
makes you want to diversify.
Let’s
assume that the basis is $10,000, and the value is $100,000. You
never sold it because you didn’t want to pay the $18,000 in
taxes ($100,000 proceeds less $10,000 basis = $90,000 gain x 15%
= $13,500).
Let’s
also assume you have a loser or losers with a combined loss of $90,000.
You sell both, winner and loser, offset the gains and the losses
and pay no capital gains. Lo and behold, you just opened up your
window to diversification and getting out of that heavy concentration
in one stock or sector problem. You repurchase the winner and the
loser or whatever you like, and your basis will be your purchase
price.
The best losses
are short-term capital losses. This is because the IRS forces you
to match short-term gains against short-term losses and long-term
gains against long-term losses first. Then the net short-term results
are netted against the net long-term results. If the result is a
gain, it will be taxable as short-term, long-term, or a combination
thereof. If the losses incurred were short-term rather than long-term,
there will be a better chance that your gain will be long-term instead
of short-term and taxed at lower rates. The short-term gains tax
rate can be almost twice the long-term gains tax rate. Therefore,
if you own losing investments that you have owned for less than
a year, they are a better choice for tax-loss selling than long-term
investments.
The following
example is somewhat complicated but it demonstrates why it is critical
to think ahead and map out a strategy to capitalize on gains and
losses.
Imagine you
hold an investment that qualifies for a short-term capital loss
(i.e., a losing investment held for less than a year) with an unrecognized
loss of $20,000. You also have a long-term winner with an unrecognized
gain of $20,000. You decide not to sell either prior to year-end.
After all you haven’t really lost any money on paper. (Hint:
This may be bad logic.)
The following
year you decide it’s time to sell the long-term winner and
recognize a $20,000 long-term gain at a long-term tax rate of 15%.
In this same year, you also incur a short-term capital gain of $10,000
from the sale of another stock. You now have $30,000 in taxable
income to recognize.
In the meantime,
the loser is still down $20,000. Fine you think, let’s sell
the $20,000 loser, offset it against the $20,000 gain, and pay tax
on the $10,000 gain. (By the time you decide to sell the loser,
it is no longer a short-term transaction because you have held it
for over a year.) When you prepare your 2003 Schedule D, you report
a long-term gain and long-term loss that net to $0. You also report
a short-term gain of $10,000 taxed at your ordinary rate of 28%
that costs you $2,800 of federal income taxes.
What you could
have done in year one was to sell the loser. In year one, you would
then realize a short-term capital loss, and deduct a $3,000 loss
at your ordinary tax rate of 28%, or $840 ($3000 x 28% = $840) and
recognize a $17,000 short-term loss carryover. In the following
year, using the netting rules, the $10,000 short-term gain would
be offset by the $17,000 short-term loss carryover. The excess short-term
loss of $7,000 would then offset the long-term gain of $20,000 leaving
you with a long-term taxable gain of $13,000. This gain would result
in tax of $1,950 ($13,000 x 15%). The net tax over these two years
is only $1,110.
In summary,
recognizing the short-term loss when you had the chance would have
saved you $1,690 or 60% in tax savings.
If your net capital losses exceed your net capital gains, you can
deduct up to $3,000 of the losses (short or long-term) against ordinary
income. That adds up to an $840 tax savings for an individual who
is in a 28% tax bracket. Be careful to avoid a wash sale, i.e.,
buying the same security back within 30 days before or after you
sell the shares. Tax rules will disallow the loss. Keep in mind,
however, that with all the stock and mutual fund choices, there
is probably a similar investment available for you to park your
money in for 30 days. This may be a better strategy than keeping
funds in cash for 30 days waiting to repurchase the same stock since
the market or the sector may move up significantly in 30 days.
Another idea
is double up in your position. Lets say you bought a stock for $50
per share that is currently trading for $20 per share. You still
think it is a good long-term investment. You are currently showing
an unrealized loss of $30 per share. If you sell now, you would
recognize a loss of $30 per share but would have to wait 30 days
to buy it back. A rise in the stock price over the next 30 days
would be lost money. You could buy a second block of the same stock
at $20 per share. Then after 30 days, sell the original block and
recognize the tax loss. You still own the same amount of shares
as before except you now have a lower tax basis in the new shares-
$20 per share. If the stock did go up during the 30-day period,
you didn’t miss out on the appreciation.
Selling investments
to realize net losses in excess of $3,000 is a good idea too. The
losses will carry over to future years when future gains can be
reduced. Plus, up to another $3,000 per year can be deducted from
ordinary income. Even if investments you currently hold recover
in value, you would have been much better off by selling them at
a loss and reinvesting the proceeds in similar investments. Using
this strategy, you will hold investments of the same value, but
with a lower cost basis and have additional tax savings each year.
To the extent that the $3,000 net loss is deducted against ordinary
income every year, you save money at ordinary tax rates. The loss
carryover can also eliminate future short-term and long-term capital
gains and will free you from subsequently sticking with investments
only because of the holding period. If the remaining investments
are subsequently sold at a gain, it will be taxed at lower long-term
gain rates, and the overall result will be less tax than holding
the original investment. If the investment with a lower basis remains
to become part of your final estate, the heirs will get a step-up
in basis and avoid the tax altogether.
Harvesting your
investment losses can reduce your capital gain income to zero and
give you a bonus of a $3,000 ordinary income reduction each year.
It’s a great way to increase the after-tax rate of return
on your portfolio without the risks of active trading. In combination
with a good asset allocation and reallocation strategy, you can
add value to your investment portfolio without increasing your investment
risk.
Finally, now
is your last chance to review your portfolio to see if you have
any net 2003 long-term capital gains that consist of pre-May 6,
2003 stock sales. The current law is still going to tax these gains
at the old long-term rate of 20%. If you are still holding stock
with both unrealized long-term gains and losses, you should consider
selling and recognizing the long-term loss stock to offset the pre-May
6th gains. This will save 5% in current year taxes. If you sell
the stock with the unrealized gains in 2004, they will be taxed
at a maximum of 15%.
If you find
all of this too overwhelming, and yet you see the inherent value
of the advice, perhaps you would be well advised to consult with
your financial advisor and your tax advisor.
P.S. On a
different note, we received glowing praise for our teleseminars
given in November. The seminar answered the most important questions
readers have about TIAA-CREF and retirement plans. We will be
making tapes, CDs and transcripts available after year end. If
you are interested in this material at the lowest possible price,
please send a blank e-mail to admin@faculty-advisor.com
and write “best price” in the subject line. This doesn’t
commit you to anything, but will insure you will get a substantial
discount if you later decide to purchase.
|
