Year-end Planning: Careful Handling of Capital Gains<br>and Losses Can Save Taxes
The market has performed well since its 2009 low. Bond prices also have soared in the past year due to decline in interest rates. Consequently, many have large gains in stocks, bonds, mutual fund shares and other investments. These taxpayers should consider whether they should sell appreciated assets this year to make use of available losses and/or to lock in this year's maximum long-capital gain rate, which may be lower than next year's rate.
Using available losses.
Long-term capital losses are used to offset long-term capital gains before they are used to offset short-term capital gains. Similarly, short-term capital losses must be used to offset short-term capital gains before they are used to offset long-term capital gains. Individuals may deduct up to $3,000 of total capital losses in excess of total capital gains as a deduction against other ordinary income.
For 2010, an individual taxpayer is subject to tax at a rate as high as 35% on short-term capital gains and ordinary income. If the EGTRRA/JGTRRA sunsets kick in, for 2011, that same type of income will be subject to tax at a rate as high as 39.6%. On the other hand, for 2010, most long-term capital gains are taxed at a maximum rate of 15% (0% to the extent the gain would otherwise be taxed at a rate below 25% if it were ordinary income). For 2011, they will be taxed at a maximum rate of 20% if the sunsets apply (18% for assets held more than five years).
You should try to avoid having long-term capital losses offset long-term capital gains since those losses will be more valuable if they are used to offset short-term capital gains or ordinary income. To do this requires making sure that the long-term capital losses are not taken in the same year that the long-term capital gains are taken.
However, this is not just a tax issue. As is the case with most planning involving investments, investment factors must be considered. You don't want to defer recognizing gain until the following year if there's too much risk that the value of the asset will decline before it can be sold. Similarly, don’t risk increasing the loss on property that you expect will continue to decline in value by deferring its sale until the following year.
To the extent that taking long-term capital losses in a different year than long-term capital gains is consistent with good investment planning, take steps to prevent those losses from offsetting those gains.
If you have no net capital losses for 2010, but expect to realize such losses in 2011 in excess of the $3,000 ceiling, consider shifting some of the excess losses into 2010. That way the losses can offset 2010 gains and up to $3,000 of any excess loss will become deductible against ordinary income in 2010.
How to preserve investment positions after recognizing gain or loss on stock.
For the reasons outlined above, paper losses or gains on stocks may be worth recognizing this year in some situations. But suppose the stock is also an attractive investment worth holding for the long term. There is no way to precisely preserve a stock investment position while at the same time gaining the benefit of the tax loss, because the so-called "wash sale" rule precludes recognition of loss where substantially identical securities are bought and sold within 30 days before or 30 days after the date of sale. Thus, you can't sell the stock to establish the tax loss and simply buy it back the next day.
However, you can substantially preserve an investment position while realizing a tax loss by using one of these techniques:
...Double up. Buy more of the same stocks or bonds, then sell the original holding at least 31 days later. The risk here is of further downward price movement.
...Sell the originals and then buy the same securities at least 31 days later.
...Sell the originals and buy similar securities in different companies in the same line of business. This approach trades on the prospects of the industry as a whole, rather than the particular stock held.
...In the case of mutual fund shares, sell the originals and buy shares in another mutual fund that uses a similar investment strategy.
Note: The wash sale rules apply only when securities are sold at a loss. As a result, you can recognize a paper gain on stock in 2010 for planning purposes and then buy it back at any time without having to worry about the wash sale rules.
Taking gains to lock in more favorable rates.
Someone with large gains and few available losses to offset them faces the difficult choice of whether to realize some gains this year to lock in the 15% rate.
As of this writing, there is still uncertainty as to whether the capital gain rates will rise next year or not. Given this, you may want to examine your portfolio now with the view to determining which assets you would want to sell should it become clear before year end that the capital gains rate will go up and whether the hike will affect you. Here, too, investment considerations should rule the day. By examining your portfolio now, you will be able to act quickly if and when next year's tax picture becomes clear.
