Breaking Down the Rules for Tax Loss Selling

With the end of the year fast approaching (only 23 trading days left), tax loss selling is a term that often returns to popularity in the investment lexicon.  Selling losing positions in the portfolio and applying them against investment gains is a great way for investors to harvest something good from a bad holding by minimizing the tax bill to Uncle Sam.

Think of it as the silver lining to come from that dog of a stock or fund pick you got from a coworker at last year’s holiday party.  But the rules can be a bit confusing and understanding them is important to making the strategy work to your benefit.

Here’s a look at a few of the key points:

• You must designate your losses as either short term (anything held less than one year) or long term (held greater than one year).
• Short term losses must be applied against short term gains and long term losses toward long term gains.  No exceptions.
• All losses that aren’t used for the current year may be carried forward into the future and used at a later date.  There is no limit to the amount you can carry forward nor is there a cutoff period for when you can use it.
• All loss selling must be settled before the last business day of the year in which you plan to realize it (so if you want to use losses in 2009, place your trades by December 28th if settlement is T+3).
• You can apply losses towards ordinary income but the limit is $3,000 in any given year

Beware the Wash Sale Rule

• The Wash Sale Rule prevents you from selling your stock or mutual fund for a loss and then turning around and buying it or something ”substantially identical” within 30 days (calendar not trading days) before or after you sell.  Doing so will invalidate your loss and result in having to pay additional taxes.
• While there is a small bit of a gray area for defining securities as substantially identical, be sure to check with your tax professional first and remember that options and similar derivative products are considered identical to their respective underlying stock.

An example of the Wash Sale Rule:

You buy 50 shares of MSFT stock for $1,500.  You sell these shares for $1,250 and within 30 days from the sale you buy 50 new shares of MSFT for $1,300.  Because you bought substantially identical stock, you cannot deduct your loss of $250 on the sale.  However, you now have to add the disallowed loss of $250 to the cost of the new stock ($1,300), to obtain your new basis, now at $1,550.

Tax loss selling is a valuable tool that investors can utilize to limit tax bills as their portfolio experiences gains.  But while understanding the rules provides a clearer picture on the approach, it’s always best to consult your tax professional first and gather a firm understanding of your own unique tax situation before implementing.

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Tagged as: Financial Planning, personal finance, Tax Loss Selling