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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 31^st 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 31^st 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.

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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.

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