Wednesday, August 6, 2014

Making The Best Of A Capital Loss

Steve Lewis for Ostrow Reisin Berk & Abrams / ORBA writes: Depending on whether you have a "glass half empty" or "glass half full" mindset, you might consider incurring a capital loss to be an unfortunate part of investing or an opportunity to lower tax liability and reposition your portfolio, respectively. While no investor wishes to experience a capital loss, being able to save some taxes can ease the sting.

On the Bright Side

A capital loss occurs when you sell a security for less than your "basis," generally the original purchase price. You can use capital losses to offset any capital gains you realize in that same tax year, even if one is short term and the other is long term.
When your capital losses exceed your capital gains, you can use up to $3,000 of the excess to offset wages, interest and other ordinary income ($1,500 for married people filing separately) and carry the remainder forward to future years until it is used up.

In with the New, Out with the Old

Years ago, investors realized it was often beneficial to sell a security to recognize a capital loss for a given tax year and then — if they still liked the security's prospects — buy it back immediately. To counter this strategy, Congress imposed the wash sale rule, which disallows losses in situations where an investor sells a security and then buys the same or a "substantially identical" security within 30 days of the sale, before or after.
Waiting 30 days to repurchase a security you have sold might be fine in some situations, but there may be times when you would rather not be forced to sit on the sidelines for a month. Likewise, you might hesitate to double up on a position in which you have a loss and then wait 31 days to sell the original stake — a strategy that also avoids a wash sale violation because the purchase occurs more than 30 days before the sale.
Fortunately, there may be another alternative. With a little research, you might be able to identify a security you like just as well as, or better than, the old one. Let us assume you own stock in a networking equipment company that has lost value since you purchased it. After researching the industry, you discover that the company's chief competitor is more attractively valued and has better growth prospects.
Your solution is now simple and straightforward — you simultaneously sell the stock you own at a loss and buy the competitor's stock, thereby avoiding violation of the "same or substantially identical" provision of the wash sale rule. In the process, you have added to your portfolio a stock you believe has more potential or less risk.
The same strategy can be applied to mutual funds. In that case, your advisor can help you identify a mutual fund or exchange-traded fund with a similar investment sector, strategy and size.

Advantageous Times

If you purchased shares of a security at different times, give some thought to which lot can be sold most advantageously. The IRS allows investors to choose among several methods of designating lots when selling securities, and those methods sometimes produce radically different results.
If you are buying mutual funds, it pays to know when the next capital gains distribution will occur and how large it will be. If the distribution is sufficiently large and the date is imminent (they often occur in December), you might want to delay your purchase to avoid incurring a sizable tax liability. At the same time, bear in mind that prior dividends paid and reinvested in mutual funds you own were taxed, and therefore increase your tax basis in the fund.

Seek Professional Advice

Given the volatile financial markets of the past few years, investors know that sometimes they must sell securities that are worth less than when they purchased them. If you incur a capital loss, discuss your options to use it to reduce your taxes and reposition your portfolio with your advisor.


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