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Tax Deductions Can Shield You From Some Capital Losses


Capital losses may be painful for investors, but they're potentially helpful for taxpayers willing to harvest the losses for current and future tax deductions.

"The only thing good about bad markets is most of your [investment] sales aren't taxable," said Philip J. Holthouse, partner in Los Angeles tax law and accounting firm Holthouse Carlin & Van Trigt. "At least losses are deductible."

There's one caveat: Paper losses don't count. To claim a capital loss on your tax return, you must have "realized" the loss by selling the investment for less than you paid. And if you have a loss within a tax-deferred account, such as a 401(k) plan, you generally can't take advantage of it. Just as profits are sheltered from tax within these accounts, so are losses.

However, if the big declines in stock prices this year--and the large recent outflow of cash from stock mutual funds--are any indication, Americans are up to their elbows in realized capital losses. Here's a primer on investment losses, when to trigger them and what to do with them.

* Triggering a loss:

To write off a capital loss, you must have realized the loss by selling the depreciated stock or fund.

For example, if you bought 100 shares of Cisco Systems at $65 a share ($6,500 total) and sold them for $10 ($1,000), you'd have a capital loss of $5,500.

That loss can be used to offset any 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."

As with most things in the tax code, however, it's not quite that simple.

To calculate your net capital gains or losses, you first must group the securities according to how long you owned them. If you held a security for a year or less before selling it, it's classified as a short-term loss or gain. If you held it for more than a year, it goes in the long-term category.

On Schedule D of your federal 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, leftover losses can be used to offset gains of the other type, if you have any.

This is a crucial exercise, because long- and short-term gains are taxed at different rates. Long-term capital gains are taxed at a 20% rate, while short-term gains are taxed at ordinary income tax rates, which can exceed 38%.

Here's how the math works: Suppose you sell your holdings of stock A, realizing a short-term gain of $1,000. You also own shares of stock B, which you bought for $3,000 but which are now worth $2,000. By selling stock B, you generate a loss that completely offsets the short-term gain from selling stock A. And since short-term gains are taxed at regular income tax rates, that would save someone in the 31% bracket $310 in federal income taxes.

A caveat: It's not always advisable to sell an investment simply to generate a tax loss. Generally you should have other reasons for wanting to sell the security--for instance, conditions in its industry have changed and you no longer think a company is a good long-term investment.

* Wash sales:

One reason you should carefully consider whether to sell a security is that so-called wash sale rules prohibit you from selling a stock to trigger a loss and then immediately repurchasing it. You must wait at least 31 days to repurchase the same security. If you purchase an identical security before that point, you'll trigger the wash sale rules, which effectively wipe away the capital loss.

What if you're a mutual fund investor and you want to sell one fund and buy another that's similar? If you purchased the identical fund, you would trigger wash sale rules, but you probably could buy another fund--even another fund that was similar to the one you just sold--without triggering a wash sale, as long as there was some difference that mattered.

For instance, you could sell one growth fund and buy another--assuming the funds had different managers and didn't own all of the same stocks. In some circumstances, you might even be able to justify buying a fund that had substantially the same investments.

For instance, you might sell XYZ Corp.'s S&P 500 index fund and buy ABC Corp.'s S&P 500 index fund if you could point to some compelling difference between the two. Such as? If ABC Corp. charged lower annual management fees on its fund; if you had other accounts with ABC and wanted to consolidate your holdings to one fund company; or if ABC could be traded on the Web, while XYZ could not, those would all be differences worth trading a security over.

* Reduce ordinary income:

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