and Sharing Your Stock Market Losses With Uncle Sam
If you've lost money in the stock market, you should be aware of the
tax breaks that capital losses can generate. In this concise summary,
you will learn how to take full advantage of capital losses and not
get caught by the tricky “wash sales” rules.
Uncle Sam is always happy to tax you when you make money. But what
happens to your tax situation when you experience losses? The crippling
3-year stock market slide that began in March 2000--call it a correction,
bear market, or anything else you fancy--produced significant capital
losses for many taxpayers, so learning how to take advantage of the
tax treatment of capital losses may be as important to you as the
recent run-up in the major stock indexes.
Generally speaking, capital gains and 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 aggregated, and up to $3,000 of a
net capital loss may be deducted against ordinary income items such
as wages. Capital losses in excess of $3,000 are 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 how long you held
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 35%, the maximum
tax rate for long-term capital gains is capped at 15%. Short-term
capital gains are taxed at ordinary income tax rates.
In addition to netting rules that apply when there are both capital
losses and gains, you also need to understand the "wash sale"
loss provisions, especially if you engage in frequent or "day"
trading. The wash sale rule is intended to prevent you from selling
assets to claim a tax loss and quickly reacquiring them. The rule
stipulates that your loss will be disallowed if you purchase substantially
identical stock or securities, including put and call options, within
30 days of the original sale.
The IRS, of course, is on the watch for wash sale violations. 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 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 sale rule prohibits 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. On the other
hand, 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 applicable to
wash sales and tax loss swapping are complex and mistakes can be expensive.
We are highly experienced with both issues. Please feel free to call
if you have questions about using your capital losses.