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Sharing Your Stock Market Losses With Uncle Sam
Uncle Sam is always happy to tax you when you make money. But what happens to your tax situation when you experience losses? The recent stock market slide—-call it a correction, bear market, or anything else you fancy--has resulted in large capital losses for many taxpayers, so learning how to take advantage of the tax treatment of capital losses may help ease some of the pain you may be experiencing. Generally speaking, as with capital gains, capital losses are reported on federal Form 1040, Schedule D, for the year in which the actual sale of capital assets such as stocks, bonds, and mutual funds occurs. A temporary decline (or increase) in the value of an asset is not reported on your tax return; the asset must actually be disposed of. In the eyes of the federal government, the old Wall Street adage applies: “You don’t make a profit or take a loss until you sell.” Net capital gains and losses are offset against each other, and up to $3,000 of capital losses may be deducted against ordinary income items such as wages. Capital losses in excess of $3,000 may be carried forward and deducted in future years, subject to the same limitation. Gains and losses from the sale or disposition of capital assets are classified as long term or short term, depending on the length of time you hold the asset. For example, a long-term capital asset is currently defined as an asset you have held for more than one year. Long-term capital gains generally receive favorable tax treatment. While the top tax bracket for ordinary income items such as wages is 39.6%, the maximum tax rate for long-term capital gains is capped at 20%. Short-term capital gains are taxed at ordinary income tax rates. New: for tax years beginning after December 31, 2000, a maximum 18% capital gains rate applies to assets held more than five years. In general, the 18% rate will only apply to assets whose holding period begins after December 31, 2000 unless a special election is made. In addition to the netting rules that apply when there are both capital losses and gains, you also need to be aware of the "wash sales" loss provisions. This is particularly important if you engage in frequent or "day" trading. The wash sales rules, which can be very complicated, basically prevent you from selling assets to claim a tax loss and quickly reacquiring them. These rules stipulate that your loss deduction will be disallowed if you purchase substantially identical stock or securities, including put and call options, within 30 days of the sale. The IRS strictly enforces and is on the watch for wash sales violations. In fact, the wash-sale period runs for a total of 61 days-30 days before and 30 days after the date of the claimed loss. Year-end sales made in December also do not escape this treatment. Even if the tax year ends during the 61-day wash sale period, the loss will still be disallowed if the wash sale period is violated. Here’s a coordinated investment and tax strategy you may want to consider. While the wash sales rules prohibit you from reacquiring substantially identical securities during the specified time period, they do not prohibit you from reacquiring comparable securities. For example, you could sell shares of a pharmaceutical stock like Merck, claim the loss for tax purposes subject to the rules discussed above, and immediately acquire shares of a comparable security such as Pfizer. This is known as tax loss swapping. The theory behind it is that if Merck (the security sold at a loss) subsequently rises, so will Pfizer (the comparable replacement security), giving you both an economic gain and the benefit of the tax loss. In theory, tax loss swapping is an excellent strategy, but it can prove risky in the real world. For example, the replacement security could go down, even if the disposed-of security recovers. Or the replacement security could rise a small amount, while the disposed-of security enjoys bigger gains. The acceptable risk and return ratio and performance spread for tax loss swapping depends on many factors, including your tax bracket, liquidity, net worth, and risk tolerance. The fundamental economics of investment decisions should not be overlooked because of the tax consequences. The laws and risks behind wash sales and tax loss swapping are highly complicated and mistakes can prove extremely costly. We are highly experienced with these issues. Please feel free to consult our office if you have any questions. |