Year's Market Losses Can Provide Tax Relief

Naturally, taxes shouldn't be the primary consideration when weighing whether to buy or sell a particular investment, such as a mutual fund. However, factoring taxes into the equation is wise, financial advisors say.

"As long as you are always weighing the pure investment decision as well as the transaction costs, it is a good strategy to try to harvest some losses while you have them," says Philip J. Holthouse, partner with the Los Angeles tax law and accounting firm of Holthouse Carlin & Van Trigt.

"If you can use losses that you were going to take anyway to shelter gains, that's worthwhile," he said.

For those who haven't had to cope with investment losses for a while, it might be helpful to review the basics:

Q: What is a capital loss?

A: It is a realized loss on the sale of securities, such as stocks or stock mutual funds, that aren't held inside a tax-favored retirement account.

For example, if you bought 10 shares of Yahoo Inc. at $245 each (or $2,450 total) and sold them for $10 ($100), you would have a $2,350 capital loss.

That loss can be used to offset capital gains--realized profits--from the sale of other investments during the year, including capital gains paid out by mutual funds in their annual "distributions."

And if your total realized losses exceed your gains--a likely scenario this year for many people--you can use up to $3,000 in excess capital losses to reduce the amount of ordinary income (such as from wages, interest or dividends) that is subject to tax.

Q: What happens if I have a capital loss within a tax-favored retirement account?

A: From a tax standpoint, losses in these accounts can't help you. Just as gains realized within a retirement account aren't taxed as they occur, you don't get to write off realized losses.

Q: How do I calculate my tax bill when I have both realized gains and losses?

A: To calculate net capital gains or losses, investors first must group the securities they sold according to how long they owned them. If you held a security for a year or less before it was sold, it falls in the short-term category; if you held it for more than a year, it's a long-term gain or loss.

On federal Schedule D of your tax return, you first offset long-term losses against long-term gains and short-term losses against short-term gains. If you have more losses in either the short-or long-term category than gains in that category, remaining losses can be used to offset the other type of gain, if any.

Q: What's the point of dividing up short-and long-term gains and losses?

A: Short-term gains are taxed at higher rates than long-term gains.

If you have more gains than losses, you would pay tax on net long-term gains at a maximum 20% rate, while net short-term gains would be taxed at your ordinary income tax rate.

Thus, if you have a lot of short-term gains, capital losses become particularly valuable because they're offsetting profits that could be taxed at rates as high as 39.6%, the top ordinary tax rate.

Q: Should I sell a stock or mutual fund that I'm holding at a loss, so I can offset gains I may have in other investments?

A: Perhaps--if you have already decided you don't want to keep that particular stock or fund for the long haul anyway.

Consider this example: You sell your holdings in ABC Co. and realize a short-term gain of $1,000. You also own $2,000 worth of XYZ Corp. stock that you bought for $3,000. You sell the XYZ shares, triggering a $1,000 loss that you can use to offset your short-term gain in ABC. Assuming you're in the 31% federal tax bracket, that transaction saves you $310 in taxes.

But if you still like XYZ as a long-term investment, selling just to take your current loss ultimately could be more costly, if the stock rebounds.

Q: If I have a loss on a stock that I still like as a long-term investment, why can't I just sell to take the loss, then immediately buy back the stock?

A: The IRS doesn't allow that. Under the agency's "wash sale" rules, if you buy a stock within 31 days of selling the same or a "substantially identical" security at a loss--that's 31 days \o7 before or after\f7 the sale--the IRS will disallow your loss, rendering it useless for tax purposes.

Q: Could I sell a stock and immediately buy an option contract to buy the stock at the same price in the future?

A: No. An option to buy the same stock would fall under the "substantially identical" umbrella as defined by the IRS, making your transaction a wash sale unless you wait the required 31 days.

Q: What if I invest through mutual funds: Could I sell one growth-stock fund and buy another without running afoul of the wash-sale rules?