Careful Handling of Capital Gains and Losses Can Save Taxes

The stock market has performed very well since its 2009 low.  As a result, many individuals may be sitting on large gains in stocks, bonds, mutual fund shares and other investment assets.  If you are in this situation, you might consider the extent to which you can sell appreciated assets this year to make use of available carryover and current year losses and/or to lock in this year's maximum long-capital gains tax rate, which may be lower than next year's maximum capital gains rate.

• Long-term capital gains rates - Barring an extension by Congress, 2010 is the final year for the lower long-term capital gains tax rate of 15% (0% to the extent the gain would otherwise be taxed at a rate below 25% if it were ordinary income).  Without an extension, starting next year, long-term capital gains tax rates will increase to a maximum rate of 20% (18% for assets held more than five years).
  
  
• Short-term capital gains rates - For 2010, individual taxpayers can be subject to tax rates as high as 35% on short-term capital gains and ordinary income.  Again, without Congressional action, those rates will increase to as high as 39.6% on short-term capital gains and ordinary income for 2011.

Thus, both the long- and short-term rates are scheduled to increase which, depending upon your unique circumstances, can have a significant impact on your tax liability, making year-end capital gains planning especially important for 2010. 

Using available losses - Long-term capital losses are used to offset long-term capital gains before they are used to offset short-term capital gains.  Similarly, short-term capital losses must be used to offset short-term capital gains before they are used to offset long-term capital gains.  Individual taxpayers annually may use up to $3,000 of total capital losses in excess of total capital gains as a deduction against ordinary income in computing AGI, and carry over to the next year the remaining losses that exceed the $3,000 limit.

A taxpayer should try to avoid having long-term capital losses offset long-term capital gains since those losses will be more valuable if they are used to offset short-term capital gains or ordinary income.  To do this requires making sure that the long-term capital losses are not taken in the same year that the long-term capital gains are taken.  However, this is not just a tax issue.  As is the case with most planning involving capital gains and losses, investment factors need to be considered.  A taxpayer will not want to defer recognizing gain until the following year if there's too much risk that the value of the property will decline before it can be sold.  Similarly, a taxpayer will not want to risk increasing the loss on property that he expects will continue to decline in value by deferring the sale of that property until the following year.

To the extent that taking long-term capital losses in a different year than long-term capital gains is consistent with good investment planning, the taxpayer should take steps to prevent those losses from offsetting those gains.

If a taxpayer has no net capital losses for 2010, but expects to realize such losses in 2011 well in excess of the $3,000 ceiling, he should consider shifting some of the excess losses into 2010.  That way, the losses can offset 2010 gains and up to $3,000 of any excess loss will become deductible against ordinary income in 2010.

Preserving your investment position after recognizing gain or loss on stock - For the reasons outlined above, paper losses or gains on stocks may be worth recognizing this year in some situations.  But suppose the stock is also an attractive investment worth holding onto for the long-term.  There is no way to precisely preserve a stock investment position while at the same time gaining the benefit of the tax loss, because the so-called “wash sale” rule precludes recognition of loss where substantially identical securities are bought and sold within a 61-day period (30 days before or 30 days after the date of sale).  The basis of repurchased shares is adjusted to reflect losses barred under the wash sale rule.  Thus, a taxpayer can't sell the stock to establish the tax loss and simply buy it back the next day. However, he can substantially preserve an investment position while realizing a tax loss by using one of these techniques:

- Sell the original holding and then buy the same securities at least 31 days later.

- Sell the original holding and buy similar securities in different companies in the same line of business.  This approach trades on the prospects of the industry as a whole, rather than the particular stock held.

- In the case of mutual fund shares, sell the original holding and buy shares in another mutual fund that uses a similar investment strategy.

The wash sale rules apply only when securities are sold at a loss.  As a result, a taxpayer may recognize a paper gain on stock in 2010 for year-end planning purposes and then buy it back at any time without having to worry about the wash sale rules.

Taking gains to lock in more favorable rates - An individual with large gains and few available losses to offset them faces the difficult choice of whether to realize some gains this year to lock in the 15% rate or to continue holding the asset(s) and selling for a profit in the future when the tax rates may be higher.  At this point in time, there is extreme uncertainty as to whether the maximum capital gains tax rate will rise at all next year, or will rise only for higher-income taxpayers.  Because the matter should be resolved before year-end by the lame duck Congress, an affected individual may want to examine his portfolio now with the view to determining which assets he would want to sell should it become clear before year-end that the capital gains rate will be hiked and, because of his income level, the hike will affect him.  Here, too, investment considerations should rule the day.  For example, an individual may be sitting on sizeable gains in bonds or bond funds.  If he feels that interest rates are not going any lower or will start to rise, it may be a good time to realize gains in bonds purely for investment reasons. Thus, such assets may be ripe for sale even if the long-term capital gains rate does not rise.  Where there is less concern that assets will remain flat or decline in value, the issue gets trickier.  Again, by examining their portfolios now, individuals will be able to act quickly if and when next year's tax picture becomes clear.

If you have questions relating to taxation of capital gains and losses, or would like to schedule an appointment to plan your year-end investment strategy, please give this office a call.

---