Capital Losses

Selling gains and holding losses is not only bad investment strategy, it's bad tax strategy. 

Even so, many investors have a tendency to sell their profitable investments and to hold their unprofitable ones. If that applies to you and if you have some capital losses, it's time to unload some of those "comeback" stocks you have been holding. Look for any forgotten investments, such as penny mining stocks, that have lost value. However, don't ignore the impact of the transaction costs in selling securities that have only lost a small amount. If it will cost you 3% to sell a stock that has declined in value by only 6%, it wouldn't pay to sell for a tax loss unless you have decided to unload the stock anyway. 

Some investors may even have some potential losses in their bond portfolio but at current interest rates, it’s unlikely that any bond losses would be significant enough to justify selling the bond to realize the loss.   

An often overlooked opportunity for tax losses is from any hard assets such as gold, diamonds or similar investments that were bought at the peak of the inflation cycle in the early 1980's. 

If any stock or bond has a loss of more than 10% of the current value, it is a strong candidate for sale to generate a tax deduction.  You can use up to $3,000 a year of deductions from losses on stocks, bonds or other capital assets to offset any other type of taxable income.  In addition, you can offset an unlimited amount of capital gains with capital losses. Clearly, it doesn't make sense to buy investments that will lose money just so you can generate some tax losses.  But most investors have accumulated some losses that they are reluctant to sell.  

 If you are in the 30% tax bracket, each $1,000 of losses in excess of your gains will save you about $300 in taxes - up to a maximum of $900 per year.  The first question is whether the commissions on selling the stocks or bonds will exceed the tax savings.  It doesn't make sense to incur $500 of commissions in order to save $300 of taxes.  But you might also ask yourself if this is a stock or bond you would buy today if you didn't already own it.  If not, then sell it and use the tax loss to offset income on other investments.  

Up to $3,000 of capital losses can be deducted each year from any other type of income including interest, dividends or even salaries.  Excess losses can be carried forward to future years, without limit.  And ... any capital losses can be deducted from capital gains without limit.  For example, if you had $10,000 of capital losses and $2,000 of gains, you would have $8,000 of net losses, and $3,000 could be deducted this year.  The remaining $5,000 could be picked up as a loss next year and could also offset any capital gains next year.  

Taking advantage of your unused losses is hopefully a one time tax savings.  Once it's done, you must move on to other tax strategies.  

LOSSES ON STOCK OF SMALL BUSINESS INVESTMENT COMPANIES

Tax Code Sections 1242 and 1243 permit investors in the stock of qualified small business investment companies to deduct any losses on the sale or worthlessness of such stock as an ordinary loss. There does not appear to be any dollar limit. The losses are treated as ordinary losses from a trade or business. Losses in excess in excess of income for a single year should be available as net operating loss deductions that can be carried back two years and/or forward for up to 20 years. (Before the 1997 tax law, net operating losses could be carried back three years and/or forward for 15 years.)

SPECIAL RULES FOR LOSSES ON SMALL BUSINESS STOCK

Section 1244 losses are deductible as ordinary losses - meaning they are not subject to the $3,000 per year limit on capital losses. Section 1244 of the tax code provides a tax break for owners of stock in small corporations that are not listed on any of the exchanges. To qualify as a small business corporation, the corporation may not have issued more than $1 million of stock in exchange for cash or other property and the corporation must be a domestic corporation

This break is only available to individual investors or to a partnership of which the individual is a member. The investor must have been the original buyer to whom the stock was issued in exchange for cash or property. An exchange for securities would not qualify. Investors in qualified corporations can deduct losses of up to $50,000 per year up to a total of $ 1 million. (That’s the maximum amount of stock of a corporation that can be issued as Section 1244 stock.) The maximum annual deduction on a joint return is $100,000 per year and it appears that all of the stock can be owned by one taxpayer on a joint return. 
 

INCOME SHIFTING

You can sometimes get more mileage out of your available capital losses if you hold your capital gains, or if you give your capital gain assets to (1) children or to (2) charity. Both of these strategies are described later in this article. There is no tax benefit to be gained by giving assets that have lost value to a child or to a charity. 

CAPITAL GAINS

Any unused capital losses will offset your capital gains and will reduce the amount of gains subject to the 15% tax. In affect, the capital losses are generating deductions at a 15% rate. If you sell the losses in a year when you have no gains, you can only deduct up to $3,000 per year of losses - but those deductions can generate tax savings at your highest marginal tax rate of up to 38.6%.
 

ESTATE AND GIFT TAXES

There is no specific estate tax benefit from cashing in your capital losses. Your taxable estate is based on the current market value of all your assets, not on the cost of the assets.

SUITABILITY

This strategy is suitable for anyone who has some investments  that have lost value and haven’t been sold.

IMPLEMENTATION

Selling a security for a capital loss is merely a matter of calling your broker and placing a sell order. Selling hard assets or real estate will require finding a buyer and may involve some advertising expenses or commissions to a broker.

TAX RISK

In selling investments to generate a capital loss with which to reduce your capital gains, watch out for the "wash sale" rule. This is a provision in the tax law that prohibits loss deductions on securities where substantially identical securities were purchased within 31 days before or after the date the loss securities were sold.  On bonds, there are brokers who can help you to switch to other bonds that have the same economic results, but are not "substantially similar" in the meaning of the tax law. The wash sale rule does not apply to hard assets such as gold, silver, rare coins, etc.   

Tax code section 267 prohibits loss deductions on sales to related taxpayers. Generally, this includes parents, children, a spouse, brothers and sisters. It does not include a son-in-law or daughter-in-law. If a husband sells property at a loss to his mother or father in law, the deduction would appear to be permitted, but if the husband files a joint return with his wife, it’s possible that the IRS will argue that the wife is a party to the loss deduction and that a sale to her parent is not deductible. I’m not aware of any cases or rulings on this.

 TAX FORMS REQUIRED

Capital losses will be reported on schedule D of form 1040.

CITATIONS

Internal Revenue Code Section 1211 and 469.