Q: Can you explain the issue of tax-loss selling?

When the end of the year approaches, it is a good time to assess gains and losses in your investment portfolio, realized or unrealized. By analyzing a portfolio's holdings and divesting its laggards, investors can reduce their tax obligations.

Investors that deftly played the market in the past and have taken sizable capital gains realized from selling investments held longer than one year will have to pay their fair share of capital gains taxes to the IRS.  Under current rules, that tax is likely to be 15% for most investors.

You Can Win for Losing

Tax obligations can be offset, though, by exiting investments whose value has fallen below their cost base through a strategy called tax-loss selling.

By divesting securities with a market value below the purchase price, an investor creates a capital loss, which can be claimed on individual tax returns. The net effect of combining capital gains and capital losses is a reduction in tax obligations.

Selling at a loss may come as a slight to an investor's ego, but it should help pacify investors' aversion to forfeiting gains to the IRS. What's more, the strategy rids a portfolio of its lagging performers and frees capital for more attractive investment opportunities.

Technical Considerations

Capital losses must first be used to offset capital gains. Only after offsetting gains, whether long-term or short-term, can a portion of capital losses be claimed against ordinary income, currently a maximum of $3,000. The remaining portion, however, can be carried forward. In other words, capital losses incurred this year can be used to help offset capital gains and ordinary income next year.

Losses claimed against ordinary income are capped on a household basis. Married couples cannot claim an amount between their returns that exceeds $3,000, whether filing jointly or separately.  

It is important to note that once a security is divested, a capital loss cannot be claimed if the identical security, or contracts or options on the same security, are repurchased within 30 days of the sale. Investors can purchase a similar security in the same industry in place of the divested holding, but the divested security itself cannot be repurchased with the expectation of claiming a capital loss. Essentially, this wash rule prevents investors from playing games with the system.

For example, if an investor took a capital loss on Countrywide Financial (CFC) and wanted to take advantage of his loss, but also believed an industry-wide rebound was about to lift lending companies, he could take a position in a stock other than Countrywide Financial, perhaps Washington Mutual (WM). Purchasing in the same industry allows the investor to claim a stake in the industry without worrying about the transaction date or forfeiting the capital loss benefit.

Decisions, Decisions

Deciding which securities to divest is the difficult task. Investors would be ill-advised to indiscriminately sell a lagging investment for the sake of offsetting capital gains.

If your portfolio's performance has been hampered by a couple of downtrodden holdings that have failed to appreciate, and you think they may fall further, perhaps it is time to let them go.

Keep in mind that even though federal income taxes for the fiscal year are not due until the following April, taxable items and tax-deductible items are only applicable for the calendar year's tax return. Always report the loss for the year in which it occurred. Do not expect to claim a loss on the 2007 return if you sell something following a nosedive in March 2008.

For more on these matters, we strongly recommend that you consult a tax advisor.

Tax-loss selling can be an effective strategy for minimizing tax obligations while increasing a portfolio's cash position for future investments. The challenge for investors, as always, is to distinguish the losers from the winners and to react objectively rather than emotionally.

--Jeffrey Ham, Briefing.com