For nearly two decades, investors have been riding a stock market roller coaster. The late 1990s tech stock boom turned into a bust in the early years of this century, as the Dow Jones Total Stock Market Index fell by nearly 45%. After a real estate-led recovery pushed stocks to new highs, a real estate collapse dropped that index more than 50% from 2007 to 2008. Since then, the index has nearly tripled; as of this writing, U.S. stocks are near record levels.
Despite this seeming up-and-down symmetry, stock market gains and losses are not taxed equally. When you file your annual income tax return, all of your net capital gains are taxed. That’s true whether you have $1,000 of gains or $100,000 of gains. Moreover, you’ll owe tax on gains taken by your mutual funds, even if you have all of your gains reinvested. (Gains in tax- favored retirement accounts aren’t taxed currently.)
Example 1: Ann Baldwin executes trades in her taxable investment account in 2015 and reports $50,000 of long-term capital gains and no capital losses. Ann also owns mutual funds in that account, which report $10,000 of long-term capital gains distributions this year, which Ann has reinvested. Ann owes tax on the entire $60,000 gain.
Example 2: Carl Davis executes trades in his taxable investment account during the year and reports $50,000 of capital losses and no capital gains. Carl, too, owns mutual funds in his taxable account that report $10,000 of long-term capital gains distributions this year, which Carl has reinvested.
In example 2, Carl reports a net loss of $40,000 for the year (netting the $50,000 loss and the $10,000 fund distribution). However, the maximum annual net capital loss deduction is limited to $3,000 per year on a single or a joint income tax return.
Therefore, Carl can deduct only $3,000 of his $40,000 net capital loss from the income on his 2015 tax return. What happens to the other $37,000 of Carl’s net capital loss in 2015? It’s a capital loss carryover, which Carl can use in the future. Such losses can offset net capital gains, dollar for dollar. Loss carryovers that aren’t used this way can be deducted each year, up to $3,000.
Example 3: Carl carries over a $37,000 net capital loss from 2015. In 2016, he has a net capital gain of $11,000. Carl can completely offset that gain with his loss carryover, so he owes no tax on his gains that year. He still has a net loss of $26,000, so he deducts $3,000 from other income on his 2016 tax return. Going into 2017, Carl has a $23,000 net capital loss carryover.
Example 4: In 2017, Carl executes no taxable trades. On his tax return for that year, he takes a $3,000 net capital loss deduction from his carryover. Going into 2018, Carl will have a $20,000 net capital loss carryover. And so on, year after year.
As you can see, taking capital losses can save taxes, now or in the future.
It may make sense to use loss carryovers as soon as possible. If you have carryover losses from the 2008 financial crisis—or even from the bursting of the tech bubble eight years earlier—the current bull market in stocks might provide opportunities to use them up.
Example 5: Erica Foster has a total of $120,000 in loss carryovers, mainly from 2000 and 2008. At present, most of the stocks Erica owns have gained value since the purchase date. Erica is concerned that her exposure to the stock market is too high.
Thus, Erica sells the stocks of seven different companies she owns, for a total gain of $105,000. Using her loss carryovers, Erica will report no taxable gains for 2015. She’ll still have a $15,000 loss carryover, so Erica can take a $3,000 deduction on her 2015 tax return, reducing her loss carryover still further, to $12,000.
Suppose, in our example, Erica is extremely concerned about a stock market pullback. She could use all the money from her stock sales to diversify away from the stock market and increase her holdings of bonds, commodities, cash equivalents, and so on. By such a move, Erica may have substantially reduced her risk in case of another stock market crash.
Liquidating stocks is not the only move you can make when you use up loss carryovers.
Example 6: Erica takes gains on seven stocks to use up most of her loss carryovers, as explained in example 5. In this scenario, though, Erica is only moderately worried about a future market crash. She uses the money from selling three of her stocks to buy bonds and increase her holdings of money market funds, reducing her stocks.
The money from selling the other four stocks is used the next day to buy back those stocks, which Erica believes have excellent future prospects. This buyback will raise Erica’s basis in those stocks, reducing the taxable gain or increasing the capital loss on a future sale.
Suppose Erica invested $25,000 in ABC Corp. in 2009. This year, she sells those shares for $40,000. As explained, Erica will owe no tax on the $15,000 gain because of her loss carryovers. After the buyback, Erica will have a $40,000 basis in ABC, not a $25,000 basis, so she’ll have improved her tax position without paying any tax.
If Erica were to sell shares at a loss and buy them back any time in the next 30 days, the wash sale rules would prevent her from using the loss on her tax return. The wash sale rules don’t apply to capital gains, though, so Erica is allowed to boost her basis in this manner. Our office can help determine if this tactic will be tax-effective for you.
If you don’t have loss carryovers from prior years, you still can benefit from knowing the tax treatment of capital gains and losses. Take losses regularly, as long as the trades fit in with your investment strategy. Use the capital losses to offset gains and take annual losses up to $3,000, whenever the losses you take during the year exceed the gains you take. Larger net losses can be carried over into future years and play a valuable role in your investment tax planning.