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Year-end planning: Careful handling of capital gains and losses can save taxes

Individuals who lost money in the stock market in 2014 may have other investment assets that have appreciated in value.As this article explains, these taxpayers should consider the extent to which they should sell appreciated assets before year end (if their value has peaked) and thereby offset gains with pre-existing losses.

Capital gain and loss basics.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.Noncorporate taxpayers may use up to $3,000 of total capital losses in excess of total capital gains as a deduction against ordinary income in computing adjusted gross income (AGI).

For 2014 and 2015, a noncorporate taxpayer is subject to tax at a rate as high as 39.6% on short-term capital gains and ordinary income.Long-term capital gains are taxed at a rate of:

…20% if they would be taxed at a rate of 39.6% if they were taxed as ordinary income,
…15% if they would be taxed at above 15% but below 39.6% if they were taxed as ordinary income, and
…0% if they would be taxed at a rate of 10% or 15% if they were taxed as ordinary income.

Note that for purposes of the 3.8% net investment income tax (NIIT) under Code Sec. 1411, net investment income (NII) includes net gain (to the extent taken into account in computing taxable income) attributable to the disposition of property, other than property held in a trade or business to which the NIIT doesn’t apply, minus the deductions that are properly allocable to that net gain.Gains taken into account in computing NII (to the extent not offset by capital losses) include gains from the sale of stocks, bonds, and mutual funds and capital gain distributions from mutual funds.

Restricting annual payouts from retirement plans and IRAs to the required minimum distribution (RMD) (and taking cash from other accounts as needed) may help some taxpayers to take advantage of a lower capital gains rate.Note, however, that gain on the sale of collectibles or section 1202 stock is taxed at the lesser of 28% or the rate at which it would be taxed if it were taxed as ordinary income, and unrecaptured section 1250 gain on the sale of depreciable real property is taxed at the lesser of 25% or the rate at which it would be taxed if it were taxed as ordinary income.

How to make the most of losses.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 as 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 won’t 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 won’t 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.

RIA illustrationEarly in 2014, Dan, a single taxpayer in the 35% tax bracket, recognized short-term capital gains of $150,000.He has not recognized any other capital gains or losses in 2014.Dan owns Corp W bonds with a basis of $800,000 that he has held for a number of years and are now worth $900,000, due solely to the decline in interest rates that took place after he acquired the bonds.He’d like to sell the bonds and invest the proceeds elsewhere, and doesn’t expect much movement in Corp W bonds over the next three or four months.Dan also owns some stock in Corp Z that he has held for more than one year, which has a value of $700,000 and a basis of $825,000.Dan expects the value of this Corp Z stock to either remain about the same or decline even more.He would like to sell the Corp Z stock.

…If in 2014, Dan sells the Corp Z stock, recognizing a $125,000 long term capital loss, and also sells the Corp W bonds, recognizing a $100,000 long-term capital gain, the long-term capital gain will be offset completely. Additionally, Dan will have $25,000 of long-term capital loss to offset $25,000 of his short-term capital gain. However, he’ll pay a $43,750 tax on the $125,000 balance of his short-term capital gain (35%).
…If Dan sells the Corp Z stock in 2014, and waits until 2015 to sell the Corp W bonds, he will have a long-term capital loss of $125,000 on the stock sale, which will offset $125,000 of his short-term capital gains if he has no other capital gains or losses in 2014. For 2014, he’ll pay $8,750 in tax on the remaining $25,000 of short-term capital gain ($25,000 × .35), and for 2015, he’ll pay tax of $15,000 on the Corp. W bond gain ($100,000 × .15) for that year. His total tax cost over 2014—2015 will be $23,750 ($8,750 + $15,000).

Thus, by taking the long-term capital losses in 2014, and deferring the long-term capital gains until 2015, Dan saves $20,000 in taxes in the two years combined ($43,750 less $23,750).

However, another consideration may be relevant to taxpayers in the situation described above.If a taxpayer doesn’t have a net capital loss for 2014, but expects to realize capital losses in 2015 well in excess of the $3,000 ceiling, he should consider shifting some of the excess losses into 2014.That way, the losses can offset 2014 gains and up to $3,000 of any excess loss will become deductible against ordinary income in 2014.

How to preserve 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).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:

…Double up. Buy more of the same stocks or bonds, then sell the original holding at least 31 days later. The risk here is of further downward price movement.
…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. A similar strategy can be used with Exchange Traded Funds.

RIA observation:The wash sale rule applies only when securities are sold at a loss.As a result, a taxpayer may recognize a paper gain on stock in 2014 for year-end planning purposes and then buy it back at any time without having to worry about the wash sale rule.