Should Tax Selling Be Part of Your Year-End Strategy?
By Janet Hill
Now
that the end of the year is upon us, many investors clean
out the underperformers in their stock portfolios before December
31, in a practice called tax selling. They sell the
declining stocks or their options at a loss to offset any
capital gains − or profits on their portfolio −
they have made during the year.
While
everyone wants their portfolio to do well, capital losses
can actually be a good thing, because you can report them
on Schedule D to reduce the taxes you have to pay. You can
use $3,000 of your capital losses per year to offset any capital
gains. Any amount in excess of that $3,000 can be carried
forward into subsequent years until it is used up. You can
use the losses to offset gains made in your securities or
real estate positions, and even to reduce your taxable income
level.
It
sounds good, doesn’t it? Sell the stock or option, collect
the loss, and then buy it back quickly before it makes any
big gains in the market and the price increases.
Not
so fast! Unfortunately, however, and not surprisingly, the
Internal Revenue Service forbids this strategy. That is why
it has a deterrent called the wash sale rule. That
means that you have to wait 30 calendar days after you’ve
sold a security for the tax loss until you are allowed to
repurchase the same security, or a “substantially identical”
one. You can buy it back on the 31st day.
The
definition of a “substantially identical” security isn’t clearly
defined, either. Index-based securities are a particularly
tricky matter: while CUSIP numbers may differ between investment
companies, the holdings are pretty much the same. What makes
matters worse is that the IRS has not clearly defined criteria
it uses to determine whether two securities are similar or
not. It says it takes all factors into account, but that leaves
a lot of room for them. A good rule of thumb is to look at
the performance graphs of your old stock and the one you’re
considering buying. If the graph patterns look very similar,
or nearly identical, you might want to keep looking.
And
don’t think you can buy twice the amount of stocks or options
you want, sell half to hedge your bets during the wash sale
period, and buy the other half back on the 31st
day. The IRS rules retroactively cover the 30-day period prior
to the sale as well, to prevent investors from “buying the
stock back” before it’s even sold.
These
rules extend to your spouse, or a corporation you control.
So you can’t sell ABC Corporation today, and have your wife
or trust buy it back tomorrow. And it’s probably not a good
idea for you to buy it through your IRA, either. While it’s
technically not a wash sale violation, it might be considered
an indirect sale to a related party, and the IRS frowns on
those, too.
If
you’re convinced that the stock has merits and is poised to
make a big gain soon, before 30 days, you can buy a replacement
stock, which is a security that shares the same asset
class, industry or sector and park your money there during
the wash sale period. For example, you could sell one computer
manufacturer stock and put the proceeds into competing company
or exchange-traded security.
However,
should you accidentally violate any provision of the wash
sale rules, you won’t be prosecuted. But the IRS will disallow
you from deducting the loss. However, you can take the loss
at a later time, as any purchase increases the cost basis
of the replacement stock. Your cost basis is the total of
the purchase price, capital gains and losses, accrued interest
and sales fees for a share of stock.
Be Mindful of the January Effect
Wall
Street likes to recite conventional wisdom, and one of its
standard truisms is that many securities do well in January.
That’s because investors who sold them off in December for
the tax benefits are buying them back after the wash sale
period. So be sure to do your selling as early in the month
of December as possible if you want to take advantage of this.
And Be Mindful of the Risks
Of
course, like any investment, there are risks associated with
these transactions. First is the possibility of market risk.
The security you sold might go up in price during the wash
sale period, so you would be forced to pay more money to buy
it back. And any individual stock you pick as a replacement
can move independently of the market. Corporations can be
susceptible to bad news that affects only them, not necessarily
their competition.
Then,
let’s discuss commissions: it is likely that you will have
to pay them when you are both selling off the security and
then buying it back. Depending on how much this will cost,
it may wipe out or significantly reduce any benefits from
the tax loss.
Finally,
tax selling is logical if you have a taxable account. IRAs
and 401(k)s already have special tax structures, so it is
probably unnecessary in most of those cases.
However,
tax savings should never be your primary concern when making
investment decisions: your long-term goals should be your
focus. And these decisions should always be made with the
help of your favorite financial professional.
*
Janet
Hill is a financial advisor practicing in Salt Lake City,
Utah. She offers Investment, Retirement, Insurance and Wealth
Management Services as a registered representative of Commonwealth Financial Network − a member firm of the NASD/SIPC.
She can be reached at
jhill@sterling-financial-group.com.
