Save Taxes: Handle Capital Gains With Care

Telling Tips, formerly Tuesday Tips, is a series of articles from local experts to help you save money, make better decisions and plan for a better future.

The stock market has performed very well since its 2009 low.  As a result, many of you may be sitting on large gains in stocks, bonds, mutual fund shares and other investment assets.  If you are in this situation, you might consider the extent to which you can sell appreciated assets this year to make use of available carryover and current year losses and/or to lock in this year’s maximum long-capital gains tax rate.

Long-term capital gains rates – Long-term capital gains are at a low tax rate of 15 percent (0 percent to the extent the gain would otherwise be taxed at a rate below 25 percent if it were ordinary income).

Short-term capital gains rates – For 2011, individual taxpayers are subject to tax rates as high as 35 percent on short-term capital gains and ordinary income.

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.  Individual taxpayers annually may use up to $3,000 of total capital losses in excess of total capital gains as a deduction against ordinary income in computing AGI, and carry over to the next year the remaining losses that exceed the $3,000 limit.

A taxpayer 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 capital gains and losses, investment factors need to be considered.  A taxpayer will not want to defer recognizing gain until the following year if there’s too much risk that the value of the property will decline before it can be sold.  Similarly, a taxpayer will not want to risk increasing the loss on property that he expects will continue to decline in value by deferring the sale of that property 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, the taxpayer should take steps to prevent those losses from offsetting those gains.

If a taxpayer has no net capital losses for 2011, but expects to realize such losses in 2012 well in excess of the $3,000 ceiling, he should consider shifting some of the excess losses into 2011.  That way, the losses can offset 2011 gains and up to $3,000 of any excess loss will become deductible against ordinary income in 2011.

Preserving your investment position 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 onto 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 a 61-day period (30 days before or 30 days after the date of sale).  The basis of repurchased shares is adjusted to reflect losses barred under the wash sale rule.  Thus, a taxpayer can’t sell the stock to establish the tax loss and simply buy it back the next day. However, he can substantially preserve an investment position while realizing a tax loss by using one of these techniques:

• Sell the original holding and then buy the same securities at least 31 days later.
• Sell the original holding 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 original holding and buy shares in another mutual fund that uses a similar investment strategy.

The wash sale rules apply only when securities are sold at a loss.  As a result, a taxpayer may recognize a paper gain on stock in 2011 for year-end 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 – An individual 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 percent rate or to continue holding the asset(s) and selling for a profit in the future when the tax rates may be higher.

If you have questions relating to taxation of capital gains and losses, or would like to schedule an appointment to plan your investment strategy, please give this office a call.

Joseph Reisman, of Joseph S. Reisman & Associates, has been serving tax prep and business accounting expertise from his Coney Island Avenue office for more than 25 years. Check out the firm’s website.