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An Upside to the Down Market: A Lower Tax Bill

Investors use tax loss harvesting to their advantage

By Fred Yager
ConsumerAffairs.com

November 23, 2008

Personal Finance • Consumer Spending, Saving, Both Rise • Economic Trends Looking Better For Consumers • Consumers Feeling Better About Financial Security • Banks See Hard Times Even After Bailout • Consumers Remain Thrifty In April • Feds Shut Down Florida Bank • Consumers Reminded to Investigate Before Investing • All 19 Banks Pass Stress Tests • TARP Ripe For Scams, Warns Inspector General • Consumers to Spend Same or More on Entertainment in 2009 • No Sign of Inflation in March • Consumers Cut Spending in March • Key Corporate Earnings Due This Week • Employers Trying To Avoid Further Job Cuts • Two Million Jobs Lost So Far in 2009 • People Feeling Economic Stress At All Turns • Consumer Prices Rise More Than Forecast • Survey Shows Consumers Preparing For The Worst • U.S. Employers Foresee Subdued Hiring Activity • Banks Lost $26 Billion in Fourth Quarter • Congress Takes Up Boomer Retirement Woes • Economists See Recession Continuing Through First Half of 2009 • Derailed Boomers Changing Retirement Plans • Recession Likely to Have Health Consequences • More Than 500,000 Jobs Lost in December • Staying Healthy in a Sick Economy • How Retirees Can Survive the Bear Market • Are Men Hardwired to Overspend? • Feds Report More Signs of Recession • Cheap Oil May Be Economic Stimulus • An Upside to the Down Market: A Lower Tax Bill • Americans Tap Savings to Cope with Economy • Economists' Panel Sees Prolonged Recession --- • More Personal Finance News

Did you know there was actually an upside to this down market? Just as the pilgrims gave thanks for their harvest, it may be fitting this Thanksgiving to give thanks to something called "tax loss harvesting." It's a little known strategy that some investors plan to use this year to take advantage of losses in the stock market to offset any capital gains and even some ordinary income tax liability.

All you have to do is sell those losers in your investment portfolio by the end of the year and you can use any losses to cash in on an equal amount of investment gains tax-free. You can even use those losses to offset up to $3,000 of ordinary income and carry over excess losses into future years.

Although you need to check with your accountant before you try to apply this strategy to your own situation, here is a short general course in a legal tax loophole that the rich have been using for years.

Tax loss harvesting

Before you can understand tax loss harvesting, you have to try to understand our complex tax laws. As written, the current tax laws allow you to "realize" losses to offset gains "realized" with other investments. Realize is just a short hand way of saying that when you sold your stock you either "made or lost" money depending on whether the sale price was higher or lower than what you paid for it. Using financial lingo, "realize" stands for that gain or loss.

In better times, logic would often dictate that when a stock price is lower than what you paid for it, you would want to hold on to it until the price goes up and then sell it so you actually make money. Granted you have to pay taxes on what you make (which is called a capital gains tax) but you still gained and that’s usually better than a loss.

But these are unusual times, when stock prices are more likely to continue going down instead of up, and when taking a loss might prove to be a gain around tax time. And taking or "harvesting" a loss becomes a prudent way of offsetting not only capital gains but up to $3,000 in ordinary income.

Short and long-term gains

To make things even more complicated, the IRS divides capital gains and losses between short-term and long-term and taxes each one differently. Short-term capital gains and losses occur when you sell a security you've owned for less than one year. Short-term gains are taxed at the same rate as your ordinary income, which means whatever tax bracket you're in, and the maximum rate is now 35 percent, that's the rate you'll pay for short term gains.

On the other hand, long-term capital gains and losses, those held for longer than one year, are currently taxed at just 15 percent.

If you sold securities, stocks, bonds or mutual funds that resulted in a long or short term capital (which means money) gain earlier in the year, you can now sell those securities and take losses in order to offset any previous gain. Long-term losses will offset long-term gains. Short-term losses will offset short-term gains. And net losses in either category will then offset gains in the other category.

If the net result is an overall loss in capital, the excess loss can be used to offset ordinary income dollar-for-dollar up to a maximum $3,000. Any excess capital losses can be carried forward indefinitely to reduce capital gains liability and ordinary income in future years. As an investment strategy, this process is known as tax loss harvesting.

"Wash Sale" rule

There, however, are some rules and restrictions. For example, the IRS will not let you take a tax loss deduction from the sale of a stock or security, if the same or a substantially identical stock or security (I'll explain this later) was purchased within 30 days before or after the sale, which adds up to a total of 60 days. This is known as the "wash sale" rule. However, any loss could be added to the cost of any new securities purchased so that when you’ve finally moved outside of the wash-sale window period of 61 days, that loss would be calculated into the selling price of the security.

Substantially identical securities

The Wash-Sale rule doesn't really spell out or define what it means by the term "substantially identical." When it comes to stocks, this term doesn't really apply since stocks are shares in a particular company and each one is different. Bonds on the other hand tell a different story. Financial experts say bonds that have different issuers or there are substantial differences in either maturity or coupon rate would not be considered substantially identical. But, if an investor finds a replacement bond with a similar coupon, duration and maturity and credit rating, yet with a different issuer, the actual composition of the portfolio would be virtually unchanged.

Preparing for future higher tax rates

Under current tax law, the maximum tax rate for long-term capital gains is 15percent, and the maximum tax rate on income for individuals is 35 percent. According to the Tax Policy Center, these rates are expected to move higher under the new Obama administration. For those in the top two income brackets, a new maximum capital gains rate of 20 percent may be created. For ordinary income, the top two income brackets may return to their 1990's levels of 36 percent and 39.6 percent.

Consult your tax advisor

You should consult with your tax advisors as to whether there are potential benefits of harvesting tax losses now versus what can be carried forward for use in the future when capital gains and ordinary income is expected to be taxed at higher rates for some individuals. Keep in mind that the administration's tax proposals must be approved by Congress. There may be state and local taxes that have to be considered. Then there also all those transaction costs, such as brokerage fees, that may apply if you are buying and selling securities. So make sure you’ve considered the complete field of pros and cons of tax-loss harvesting before reaping this crop.

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Fred Yager, a veteran AP and CBS News journalist, was formerly president of Merrill-Lynch Broadcasting.

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