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How to Offset Capital Gains and Losses

If you have recently taken the plunge into the stock market, you may have to report capital gains and losses on your personal tax return. Don't the gains and losses simply cancel each other out? Actually, it's more complicated than that. In fact, even seasoned investors are often perplexed by these tax rules.

For the sake of simplicity, we will limit this discussion to capital gains and losses from sales of securities, assuming that you have no other capital asset transactions. (Other special rules apply to sales of collectibles and property that is subject to depreciation recapture.)

Starting point: There are different rules for long-term gains and losses versus short-term gains and losses. A gain or loss is “long-term” if you have held the security for more than one year before the sale occurs. For example, if you bought stock on December 1, 2005, and you sell it at a profit on November 30, 2006, the gain is treated as a short-term gain. But holding the stock for just two more days—until December 2—results in a favorably taxed long-term capital gain.

To net your gains and losses, first put your long-term gains and long-term losses in one basket. This gives you either a net long-term gain or a net long-term loss. Next, put your short-term gains and short-term losses in another basket. This results in either a net short-term gain or a net short-term loss. Finally, combine the net long-term gain or loss with the net short-term gain or loss to arrive at an overall net capital gain or loss.

If your capital gains from your annual stock market activities exceed your losses, any net long-term gain is taxed at a maximum tax rate of 15% for someone in the 25% tax bracket or above (5% for someone in the 10% or 15% bracket). On the other hand, if your capital losses exceed your gains, the net loss can be used to offset up to $3,000 of ordinary income such as salary from your job. Any excess is carried over to future years.

Once you understand the netting rules, analyze your current tax situation and act accordingly. The end of the year is the optimal time to maximize tax benefits. For example:

*If you are currently showing a net loss, you can realize capital gains before the end of the year. The capital gains are effectively tax-free up to the amount of your losses.

*If you are currently showing a net gain, you can realize capital losses before the end of the year. The losses effectively absorb the tax you would have had to pay on the gains.

*If the situation dictates it, you can realize an excess loss that may be used to offset up to $3,000 of ordinary income.

Caution: If you sell a stock and buy back the same stock within 30 days, you cannot deduct the loss on your tax return. This is called the “wash sale” rule. To avoid this harsh tax result, wait at least 31 days before you reacquire the stock. Alternatively, if you believe the stock is now poised to rebound, you can “double up” your shares and sell the original shares more than 30 days later. This strategy enables you to lock in the current price without forfeiting the tax loss.

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	[ return to list ] How to Offset Capital Gains and Losses If you have recently taken the plunge into the stock market, you may have to report capital gains and losses on your personal tax return. Don't the gains and losses simply cancel each other out? Actually, it's more complicated than that. In fact, even seasoned investors are often perplexed by these tax rules. For the sake of simplicity, we will limit this discussion to capital gains and losses from sales of securities, assuming that you have no other capital asset transactions. (Other special rules apply to sales of collectibles and property that is subject to depreciation recapture.) Starting point: There are different rules for long-term gains and losses versus short-term gains and losses. A gain or loss is “long-term” if you have held the security for more than one year before the sale occurs. For example, if you bought stock on December 1, 2005, and you sell it at a profit on November 30, 2006, the gain is treated as a short-term gain. But holding the stock for just two more days—until December 2—results in a favorably taxed long-term capital gain. To net your gains and losses, first put your long-term gains and long-term losses in one basket. This gives you either a net long-term gain or a net long-term loss. Next, put your short-term gains and short-term losses in another basket. This results in either a net short-term gain or a net short-term loss. Finally, combine the net long-term gain or loss with the net short-term gain or loss to arrive at an overall net capital gain or loss. If your capital gains from your annual stock market activities exceed your losses, any net long-term gain is taxed at a maximum tax rate of 15% for someone in the 25% tax bracket or above (5% for someone in the 10% or 15% bracket). On the other hand, if your capital losses exceed your gains, the net loss can be used to offset up to $3,000 of ordinary income such as salary from your job. Any excess is carried over to future years. Once you understand the netting rules, analyze your current tax situation and act accordingly. The end of the year is the optimal time to maximize tax benefits. For example: If you are currently showing a net loss, you can realize capital gains before the end of the year. The capital gains are effectively tax-free up to the amount of your losses. If you are currently showing a net gain, you can realize capital losses before the end of the year. The losses effectively absorb the tax you would have had to pay on the gains. *If the situation dictates it, you can realize an excess loss that may be used to offset up to $3,000 of ordinary income. Caution: If you sell a stock and buy back the same stock within 30 days, you cannot deduct the loss on your tax return. This is called the “wash sale” rule. To avoid this harsh tax result, wait at least 31 days before you reacquire the stock. Alternatively, if you believe the stock is now poised to rebound, you can “double up” your shares and sell the original shares more than 30 days later. This strategy enables you to lock in the current price without forfeiting the tax loss. [ return to list ]
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