Tax planning can’t restore your losses, but it can soften the blow. Using losses to reduce taxable gains by means of tax-savvy realization of losses to match gains is referred to as tax loss harvesting or tax loss selling. Although the market has recovered from its low points in 2008, many taxpayers still own investments whose current market value is worth less than the tax basis in those specific investments. On the other hand, many investors scooped up solid blue chip stocks at their depressed lower prices last year. I’m also betting that some of those same stocks have been sold in 2009 as the market has made a modest recovery. It would behoove these investors to review their portfolios to for any tax loss harvesting strategies before the end of 2009. An individual, prior to year-end, should review all year-to-date security transactions to calculate any current year net realized gains while also reviewing any prior year loss carryovers they might have from last year. Financial planners and advisors who understand and apply these principles really do offer “value added service.” Proper tax loss harvesting strategies can save you taxes and help you diversify your portfolio in ways you may not have considered. If you haven’t yet harvested your losses this year, please review your situation and act accordingly.

For those of you who also invest in mutual funds, it would be really prudent to calculate, if applicable, the amount long-term capital gain distributions that their mutual fund(s) will be reporting as taxable in 2009. Selling some of your investments and recognizing taxable losses should eliminate that gain. In fact, selling enough shares to not only eliminate the gains but to have excess losses of $3,000 that can be used to offset ordinary income at your highest marginal rate is usually the best plan. If you’re in the 25% tax bracket, that means an extra $750 or more in your pocket. Theoretically, this represents an interest-free loan on future capital gains that you will otherwise owe. Also, isn’t $750 today worth more than the eventual $750 that you will repay in the future?

Hedging Against Higher Future Capital Gain Rates

Capital gains tax rate increases on the wealthy is an anticipated change in the new President’s tax agenda. The talk in Washington is that the proposed capital gains tax increases will most likely not happen until the Tax Increase Prevention and Reconciliation Act of 2005 signed by former President Bush expires at the end of 2010. President Obama has proposed tax rate increases on long-term capital gains from the current top rate of 15% to 20% or even higher. The middle and lower income class taxpayer rates would remain the same. In fact, next year may be the right time to recognize long-term gains on appreciated stock at lower rates if your capital gains rates are going up in 2011 because you are a higher income taxpayer.

If you look at the proposed capital gains tax rate increases, wouldn’t your losses be worth more if you paid tax on any gains this year at lower rates while preserving the losses on those losers to offset gains in the future at higher tax rates? That certainly is sound thinking. What happens if you die while your portfolio is under water? The step down in basis on those inherited shares would not allow your beneficiaries to recognize those losses, thus, they are gone forever. Recognizing those losses can reduce that risk factor. Everybody is not in the same situation so there are no “one-answer-fits-all” solutions.

How can you hedge against long-term capital gains rates going up in the future? What if you sell low basis stock today, recognize the long-term capital gains on those sales and immediately buy back the same stock. You can offset those gains by tax loss harvesting and be in the same tax position at the end of the day. You now have a new higher tax basis in those shares that you repurchased. You have in effect reduced future gains on those shares. If you subsequently sell those repurchased shares in a long-term stock sale transaction, you would have a smaller gain to report at the new higher tax rate. Of course, there are always other considerations to consider.

When Not to Tax Loss Sell

If you offset capital gains that would have otherwise been tax-free (because your capital gains tax rate is 0%) then this part of your tax loss harvest might be an outright loss. If you reinvest the loss harvest dollars in the same or similar security, you now have a lower tax basis in that investment. If that investment recovers, and the net result is a future gain, you may end up paying capital gains tax when you sell. Unless you know for sure that your future capital gains tax rate is 0%, then harvesting those losses would result in a financial loss. Fundamentally, you get no benefit by offsetting capital gains that are going to be tax-free anyway. Thus, if you are in the 0%, 10% or 15% tax bracket this year and expect to be in a higher tax bracket in 2010, you may want to recognize a tax-efficient amount of long-term built-in gains on low basis investments in 2009. You can lock in the 0% tax rate by selling the shares and re-establish a new higher tax basis by immediately buying back those same shares. You need to “run the numbers” to make sure that the additional capital gain income (although hypothetically at a 0% tax rate) doesn’t end being taxed at a much higher marginal rate than expected. There is only a limited amount of long-term gains that can be tax-free based on each taxpayer's situation.

Avoid the Wash Loss Rules

Be careful to avoid a wash sale, i.e., buying the same security within the 30-day period (calendar days, not trading days) before and after you sell the shares -- the tax rules will disallow the loss. Having your tax accountant tell you that your apparent loss is not deductible this year will leave you with a sick feeling. Should you repurchase less than the total number of shares that you sold, only a portion of the loss is disallowed, and the remaining portion is deductible?

Just for peace of mind, go back and review your stock sale transactions and make sure any loss you think you are entitled to write-off in 2009 isn’t disallowed by the wash loss rules. You could still preserve the loss by selling that entire position before year-end and buying it back again after 30 days. That transaction is pretty much black and white. Watch out for this little known “wash sale” traps that most taxpayers and even advisors may overlook. If you buy back the same security in your IRA or other retirement accounts, or a have a related person buy the stock during the same 30-day period, you also have a “wash sale” in your after-tax account transaction. Lastly, if you have more than one brokerage account, make sure you review all of them when looking for wash sale transactions. Please make sure that you understand “wash loss” rules because there are many situations and rules not covered here.

Other Advantages of Reducing Capital Gains

Also, keep in mind that reducing your adjusted gross income may enable you to qualify for other tax-related benefits that are tied directly to reducing your adjusted gross income. A few of these are reduced taxable social security benefits, qualifying for a Roth conversion or just freeing up more to convert to a Roth IRA at desired tax bracket. Qualifying education related credits or deduction, lower AMT tax, and smaller phase outs of your itemized deductions and personal exemptions can also benefit taxpayers by having a lower adjusted gross income. Part B medicare premiums deducted from retired Social Security recipients can be adversely affected (i.e., you get charged a higher monthly premium) if your capital gain income increase is too high. Although you may be able to fight the social security office arguing this was a one-time increase to your income, winning is not a guarantee. Offsetting those gains assures you a victory. These are all advantages of tax loss selling.

Tax Loss Selling Examples

Assume you have a winner—you bought it for $50, it is now worth $100, and there is no adjustment to the basis. Also, please assume, you have a loser; you bought it for $100, and now it is worth $50. Let’s assume you are in the 25% tax rate table for federal purposes and both transactions qualify as a long-term sale. What are your options?

Idea 1: Buy and Hold

Do nothing, buy and hold. No taxes on any transaction. Next year, if you sell the winner, perhaps in a rebalancing or diversification attempt, and hold on to the loser, you will have to pay $7.50 in capital gains tax ($50 x 15% tax = $7.50 tax).

Idea 2: Dump the Loser

Sell the loser, and deduct $50 in losses. This means you will pay $12.50 less in taxes than you would have if you had done nothing (Idea 1). Knowing that you will pay $12.50 less in taxes (the 25% of your losses that you can deduct), you can afford to reinvest $62.50 (the $50 sale price of the investment, plus the $12.50 tax savings; subject to limitations), which is 25% more than your losing investment was worth ($62.50 is 25% more than $50). So, you get an immediate $12.50 benefit. When you consider state capital gains taxes, the savings could be greater.

If you later sell the winner for $100 and have to pay capital gains tax of $7.50 ($50 x 15%) at least you enjoyed the time value of your $12.50 while you held the stock. If you can use other losses to offset the winner, you would be $12.50 ahead plus the growth on the $12.50 over time.

Idea 3: Dump the Loser and Repurchase

Let’s assume you like the loser or it is a “core holding” of your portfolio or you think the loser will come back. Sell the loser and then, while avoiding the wash rules, buy it, or something similar to it, back. Assume you made the correct decision to sell and repurchase. After repurchasing the loser for $50, its value climbs back to $100. Except for transactions fees, you would have the benefit of the $12.50 savings you made by deducting the loss, and you have the growth. Furthermore, you have maintained the integrity of your portfolio.

Idea 4: Dump the Winner

This can be a good strategy in times of increasing capital gains rates. If you dump the winner and keep the loser, you will pay the 15% tax of $7.50 on the $50 gain now. Ignoring subsequent investment value changes, if capital gains go up to 20% in the future and you sell the loser, you can save 25% ordinary taxes if you have no other gains, or if you do have other gains, you can save 20% capital gains tax or $10, which is more than the $7.50 you paid in the current year.

Use Your Losses to Diversify Your Portfolio

Now let’s assume you have a heavy position in a particular stock or mutual fund in a particular sector (like a large cap fund) that has a low basis. You have avoided selling it for years because you don’t want to pay the capital gains tax. Then, either your advisor nags you or the fear of an Enron scenario makes you want to diversify. Let’s assume that the basis is $10,000, and the value is $100,000. You never sold it because you didn’t want to pay the $13,500 in taxes ($100,000 proceeds less $10,000 basis = $90,000 gain x 15% = $13,500).

Let’s also assume you have a loser or losers with a combined loss of $90,000. You sell both, winner and loser, offset the gains and the losses and pay no capital gains. Lo and behold, you just opened up your window to diversification and getting out of that heavy concentration in one stock or sector problem. You repurchase the winner and the loser or whatever you like, and your basis will be your new purchase price.

Selling Before or After Distributions

The general rule is to sell a fund before and buy the fund after a dividend and capital gain distribution. The fundamental reason for this is the NAV of mutual funds will drop in value commensurate to the size of the distribution. A dollar of distribution will increase the tax loss by one dollar. On the other side of the transaction, the distribution will result in increased taxes. The distribution can be a qualified dividend, ordinary dividend or a capital gain distribution. These distributions can be taxed at your ordinary marginal rates, qualified dividend rates or long term capital gains tax rates. By selling before the distribution date you can lock in the loss. An example might help clarify the concept.

Let’s say you have $4,000 of long-term capital gain income from a stock that you sold earlier in the year, and you are in the 25% marginal tax bracket. You’re looking to harvest the $3,000 built in loss of your mutual fund by selling it before the distribution date and pay long-term capital gains tax of $150 ($4,000 - $3,000 x 15%). Conversely, you hold off and sell the same fund after the distribution date. The fund makes a $300 dividend distribution that is not eligible for lower qualified dividend tax rates. Right after the distribution the funds total NAV drops by $300 that also increases your total stock loss to $3,300. The tax you now pay on your net stock gains for the year is $105 ($4,000 -$3,300 x 15%). In addition to the capital gains tax, you also have to pay $75 tax on the $300 dividend distribution ($300 x 25% marginal tax rate). By selling the fund before the distribution date, your total tax cost is $150 compared to $180 total tax cost by selling after the distribution date. At best, if the $300 distribution is taxed as a long-term capital gain distribution, you are no better or worse off. So there is no benefit to selling after a distribution and actually a risk of increased taxes.

Strategically Use Short-Term Losses

The best losses are short-term capital losses. This is because the IRS forces you to match short-term gains against short-term losses and long-term gains against long-term losses first. Then the net short-term results are netted against the net long-term results. If the result is a gain, it will be taxable as short-term, long-term, or a combination thereof. If the losses incurred were short-term rather than long-term, there will be a better chance that your gain will be long-term instead of short-term and taxed at lower rates. The short-term gains tax rate can be almost twice the long-term gains tax rate. Therefore, if you own losing investments that you have owned for less than a year, they are a better choice for tax-loss selling than long-term investments.

The following example is somewhat complicated but it demonstrates why it is critical to think ahead and map out a strategy to capitalize on gains and losses.

Imagine you hold an investment that qualifies for a short-term capital loss (i.e., a losing investment held for less than a year) with an unrecognized loss of $20,000. You also have a long-term winner with an unrecognized gain of $20,000. You decide not to sell either prior to year-end. After all you haven’t really lost any money on paper. (Hint: This may be bad logic).

The following year you decide it’s time to sell the long-term winner and recognize a $20,000 long-term gain at a long-term tax rate of 15%. In this same year, you also incur a short-term capital gain of $10,000 from the sale of another stock. You now have $30,000 in taxable income to recognize.

In the meantime, the loser is still down $20,000. Fine you think, let’s sell the $20,000 loser, offset it against the $20,000 gain, and pay tax on the $10,000 gain. (By the time you decide to sell the loser, it is no longer a short-term transaction because you have held it for over a year). When you prepare your Schedule D, you report a long-term gain and long-term loss that net to $0. You also report a short-term gain of $10,000 taxed at your ordinary rate of 28% that costs you $2,800 of federal income taxes.

What you could have done in year one was to sell the loser. In year one, you would then realize a short-term capital loss, and deduct a $3,000 loss at your ordinary tax rate of 28%, or $840 ($3000 x 28% = $840) and recognize a $17,000 short-term loss carryover. In the following year, using the netting rules, the $10,000 short-term gain would be offset by the $17,000 short-term loss carryover. The excess short-term loss of $7,000 would then offset the long-term gain of $20,000 leaving you with a long-term taxable gain of $13,000. This gain would result in tax of $1,950 ($13,000 x 15%). The net tax over these two years is only $1,110.

In summary, recognizing the short-term loss when you had the chance would have saved you $1,690 or 60% in tax savings.

Keep Track of Specific Stock Lots to Your Advantage

Many investors fail to maximize the tax benefits by specific lot selling. Keeping track of your stock purchases at lot levels allows for greater control when instructing your broker to sell shares. If you use specific lots to your advantage, you can then pick which lots to sell - the ones creating gains or the ones creating losses or less in gains -- as need be in your situation.

Consider Realizing More Than $3,000 in Net Capital Losses

If your net capital losses exceed your net capital gains, you can deduct up to $3,000 of the losses (short or long-term) against ordinary income. That adds up to an $840 tax savings for an individual who is in a 28% tax bracket. Selling investments to realize net losses in excess of $3,000 is a good idea too. The losses will carry over to future years when future gains can be reduced. Plus, up to another $3,000 per year can be deducted from ordinary income. Even if investments you currently hold recover in value, you would have been much better off by selling them at a loss and reinvesting the proceeds in similar investments.

However, by using this strategy, you will hold investments of the same value, but with a lower cost basis and have additional tax savings each year. To the extent that the $3,000 net loss is deducted against ordinary income every year, you save money at ordinary federal tax rates. The loss carryover can also eliminate future short-term and long-term capital gains and will free you from subsequently sticking with investments only because of the holding period. If the remaining investments are subsequently sold at a gain, it will be taxed at lower long-term gain rates, and the overall result will be less tax than holding the original investment. Pennsylvania residents need to keep in mind that any excess capital losses are not available for carryover to offset future gains.

Conclusion

Now is the time to review your portfolio's investments noting the costs, values, and purchase dates of each security. Harvesting your investment losses can reduce your capital gain income to zero and give you a bonus of a $3,000 ordinary income reduction each year. It’s a great way to increase the after-tax rate of return on your portfolio without the risks of active trading. In combination with a good asset allocation and reallocation strategy, you can add value to your investment portfolio without increasing your investment risk.

James Lange is a tax attorney and CPA with a thriving retirement and estate planning practice in Pittsburgh, Pennsylvania.  He focuses on the unique needs of individuals with appreciable assets in their IRAs and 401(k) plans.  His plans include tax-savvy advice, will and trust preparation, and intricate beneficiary designations for IRAs and other retirement plans.  Jim's advice and recommendations have received national attention from syndicated columnist Jane Bryant Quinn, and his articles are frequently published in Financial Planning, Kiplinger's Retirement Report and The Tax Adviser.