Taking Securities Losses

The stock market has been up and down throughout 2011. If you have losses on stocks, exchange-traded funds (ETFs), bonds, and mutual fund shares between now and the end of the year, you may want to capitalize on them for tax advantage.

Review your portfolio now

Determine the amount of actualized losses you have as well as what paper losses you are sitting with. This can help you decide what additional sales, if any, you want to make before the end of the year. Also review your gains, both actualized and those on paper.

Capital losses

Your capital losses can offset capital gains. While there is an ordering rule for applying losses first against certain gains (e.g., short-term losses first offset short-term gains; then excess short-term losses can offset long-term losses). For instance, if you have $6,500 of capital gains for the year and $6,500 of capital losses, you won’t have any net gains on which to pay tax. But you may want to take additional losses, beyond the amount of your gains for the year. Here’s why:

• Capital losses in excess of capital gains for the year can offset ordinary income, such as salary and interest income, up to $3,000 ($1,500 for a married person filing a separate return).
• Capital losses in excess of capital gains and the $3,000 ($1,500) deduction limit can be carried forward and used in subsequent years. There is no time limit on capital loss carryforwards for individuals.

When couples file jointly, it doesn’t matter which spouse had the loss, because it is reported on their Schedule D. However, if couples file separate returns, any capital loss belongs solely to the spouse who was the owner of the security that generated the loss.

Wash sale rule

You can’t churn your holdings solely for tax advantage without really changing your economic position. This is because there is a restriction in the tax law on deducting losses, called the wash sale rule. This rule prevents you from recognizing a loss on the sale of a security if you acquire a substantially identical security, such as a stock, bond, or mutual fund share, within the wash sale period. This is 30 days before or after the date of sale. For instance, if you sell 10 shares of X Corp. at a loss on November 30 and 2 weeks later on December 14 you buy 10 shares of X Corp., you cannot deduct the loss on the November 30 sale.

The loss from a wash sale is preserved in the basis of the newly acquired security so that eventually you can use it to your advantage. You add the disallowed loss to the basis of the new security and when the newly acquired security is eventually sold, the deferred loss will be recognized. Alternatively, any gain on the sale will be minimized to the extent of the deferred loss.

Sales to related parties

You cannot get around the wash sale rule by selling securities to a “related party.” If you sell a stock or bond, such as a security from a privately held corporation, directly to a person who is considered a related party, no loss deduction is allowed. A related party for purposes of the wash sale rule includes most close relatives, including a spouse, child, grandchild, parent, grandparent, or sibling. Other relatives, such as in-laws, aunts and uncles, and nieces and nephews, no matter how personally close you feel to them, are not related parties.

The related party rule isn’t limited to sales to your relatives. It also applies to sales to a related corporation one in which you own more than 50 percent of the value of the stock and certain other controlled entities, such as trusts and estates. And it applies to deferred accounts as well as taxable accounts. For example, you cannot sell securities in your personal account and then cause your IRA to buy substantially identical securities because the IRA is considered a related party.

Conclusion

While no one wants to have economic losses, there can be tax benefits to them. Do not sell only for tax breaks; work with a financial advisor to make sure the sales fit into your overall financial picture. Use the sale proceeds to upgrade your portfolio.