Looking at year-end tax-loss planning

By James Quackenbush The Daily Record Newswire As 2011 quickly comes to an end, individuals with taxable investment accounts should be taking advantage of tax-saving strategies before the year is over. Year-end tax planning can be a valuable and money-saving opportunity that should not be overlooked. Therefore, if you are holding investments in stocks, mutual funds and bonds that are worth substantially less than the original purchase price, you should consider selling those investments before the year is over. Through a process known as tax-loss selling, you can help reduce tax obligations on investment profits made throughout the year. What is tax-loss selling? Tax-loss selling is the process of selling investments that are worth less than the purchase price, in order to realize a loss. An investment loss cannot be realized until the investment is sold and must be sold before the close of business on Dec. 31 to be eligible for that year's tax reporting. Once a loss has been realized, it can be used to offset other gains that were produced throughout the tax year. If the amount of losses that are realized outweigh the amount of gains for the tax year, taxpayers can deduct up to $3,000 of the outstanding tax loss against ordinary income made through the year. If there are any unused tax losses, the losses can be carried forward to offset future gains. Realized gains are categorized into short-term and long-term capital gains and are taxed at two different tax rates. Short-term capital gains (investments held less than one year) are taxed at an individual's ordinary income tax rate, which can be as high as 35 percent. Long-term capital gains (investments held more than one year) are currently taxed at a special rate of 5 or 15 percent, depending on an individual's marginal tax bracket. How does tax-loss selling work? Let's assume an investor originally invested $25,000 in XYZ Corporation and the value of the stock is now worth $10,000. The position can be sold, and a loss is created on the difference of $15,000. This loss can now be used to offset other capital gains that have occurred during the year. If the investor already had capital gains for the year of $5,000, by selling the XYZ Corporation, his or her tax liability is reduced to zero, and $10,000 in remaining losses can be applied to future capital gains. For tax-reporting purposes, short-term gains and losses are first netted against each other for the tax year. Next, long-term gains and losses are netted. Finally, the remaining outcomes are combined. As a result, a net short-term loss of $15,000 can be applied against a net long-term gain of $5,000 for a remaining short-term loss of $10,000. Given the recent volatility in the stock markets, the amount of losses an individual can generate could be significant. As mentioned before, if your loss outweighs your gain, you can claim up to $3,000 of the losses against your ordinary income and the remaining losses can be used to offset future gains. In the above example, the remaining $7,000 can be applied to future gains. Why take advantage of tax-loss selling? Investors have enjoyed a special long-term capital gain tax rate since 2003, thanks to the Bush tax cuts. However, with the government looking for ways to increase tax revenue, this benefit is likely to expire after Dec. 31, 2012. Starting in 2013, the tax rate on long-term gains will revert to the traditional 20 percent tax rate or possibly even higher. When tax rates increase, having large tax-loss carry forwards that can be used against future gains will be even more beneficial from a tax-savings standpoint. The Wash Sale Rule When considering this tax management strategy, you should be aware of the wash sale rule. Under the wash sale rule, the IRS will not allow you to realize a loss on the sale of an investment if you repurchase it within 30 days of the sale date. For example, if you own 100 shares of XYZ Corporation and know that you are going to sell the stock to realize the loss but still want to maintain your position in the company, you cannot buy an additional 100 shares on Nov. 30 and sell your original share lot on Dec. 20. Additionally, you cannot sell your position in the stock on Dec. 20 and then buy it back on Jan. 15; you must wait at least 31 days before repurchasing the position. However, you may buy a similar security that will highly correlate with the return of the one that you sold. For example, if you sold a technology stock such as Microsoft, you could buy an exchange-traded fund that would correlate with returns from the technology sector, such as the Technology Select Sector Spyder Fund (XLK). Tax-loss selling is an excellent strategy for reducing your tax burden on investment gains. It gives investors both a chance to sell investments that have performed poorly and an opportunity to reorient investment portfolios for the future. However, before making any end of the year tax planning decisions, please consult with your accountant and investment professional to ensure such a strategy would prove beneficial to your portfolio. ---------- James Quackenbush is an analyst/portfolio manager for Karpus Investment Management, a local independent, registered investment advisor managing assets for individuals, corporations, nonprofits and trustees. Offices are located at 183 Sully's Trail, Pittsford, N.Y. 14534; phone (585) 586-4680. Published: Thu, Dec 22, 2011