Tax-loss selling is a means of lowering your tax burden by selling off underperforming stocks or securities at a loss. The resulting loss may be used to offset capital gains (if you’ve held the stock for more than a year) or ordinary income (if you’ve held it for less than a year). In either case, you can simultaneously lower your overall tax burden while ridding yourself of poorly performing assets.
To understand how this works, it's important to note the difference between long and short-term capital gains. If you sell an investment that you have held for one year or less, proceeds are considered short-term capital gains and are taxed at the same rate as your income. If you sell an investment that you held for over one year, the proceeds are long–term capital gains and are taxed at a lower rate (15% for most taxpayers, 20% for those in the highest income tax bracket).
IRS form Schedule D determines your eventual gain or loss for taxation purposes. In essence, you calculate your net gain or loss from short-term and long-term capital gains separately and add the two together. This number determines the gain on which you will pay capital gains taxes, or the loss you can deduct from your taxable income – up to $3,000 in that year. However, you can carry over larger losses to deduct from succeeding years' capital gains (and up to $3,000 in income).
Doing a mock Schedule D will help you decide if you have enough losses to engage in tax-loss selling, and portfolio analysis will help you decide which investments to sell. If you decide to proceed, consider these tips:
- Time Your Sale – Because you are offsetting the years' capital gains, most tax-loss selling occurs in December. Be careful – to qualify, sales must settle before the last business day of the year.
Prices may be pushed artificially low in December as folks jettison underperforming stocks. You may benefit by shedding poorer performing stocks earlier in the year – see the "wash rule" below.
- Offset Short-Term Capital Gains – It's important to offset short-term capital gains, as they are taxed at the higher rate. Selling to offset long-term capital gains must be considered against the current and expected future value of the stock. Do a cost-benefit analysis, or ask a tax/investment professional for assistance.
- Beware Of The Wash Rule – If you expect a stock to rebound, why not sell in December to offset gains and buy them back in January? The wash rule was instituted to keep people from doing just that.
If you are declaring the sale of a stock as a capital gains loss, you can't buy a reasonably identical replacement stock for 30 days on either side of the sale (before or after). You can repurchase after this time, or you can sell earlier and try to time the stock rebound. For example, if you sell the stock at a loss in September and the price is even lower in December, you can buy it back and claim the earlier loss on your taxes.
Whether this is a smart move depends on when the stock rebounds – you may have been better off selling in December and taking a larger loss off your capital gains taxes (assuming you had more gains to negate). Wash rule interpretations can be murky and complex, and it is wise to consult a tax professional before acting.
The rules governing tax-loss selling can be complex, and are subject to change. If you don’t have a perfect understanding of these rules, get some professional guidance. Otherwise, you may inadvertently negate your tax advantages. Remember, you are making the best of a bad situation and limiting your losses in certain investments by selling them to cut losses and claiming a tax advantage at the same time. You don’t want to learn later that the whole exercise was for naught.
Calculate your tax bracket.