Tax Laws May Let You Squeeze Lemonade from Stock Market Lemons

(RIVERWOODS, ILL., January, 2009) – Some investors who were battered by the bearish stock market last year will be able to ease their pain a bit when they fill out their 2008 tax forms, according to CCH, a Wolters Kluwer business and a leading provider of tax, accounting and audit information, software and services (CCHGroup.com). Others will have the opportunity to apply some tax salve to investment wounds by making the right moves this year. But it takes careful record keeping and shrewd moves to make the most of the tax code’s provisions for stocks and other investments that go sour.

“If your investments lose value, the tax laws won’t restore your fortunes, but they can lessen the pain of your losses,” said CCH Principal Federal Tax Analyst Mark Luscombe, JD, LLM, CPA. “There are ways for investors to use losing stocks to offset gainers and even shelter ordinary income from taxes. But you have to know the rules, know the tax status of your investments and be willing to sell.”

Only “Realized” Gains and Losses Count

Being willing to sell both winning and losing investments is central to tax planning, because the tax laws generally recognize only “realized” gains and losses – stocks, bonds and mutual fund shares that are actually sold for a profit or a loss during a tax year. Gains and losses that exist only on paper don’t count.

“Many people are reluctant to admit they made a mistake, and so they hold on to a losing stock in hopes that it will rise again,” Luscombe noted. “They also may be reluctant to sell a winning stock, even if selling a little earlier rather than later means they can minimize taxes on their gains. They often have to choose between actions that produce tax advantages and those that maximize investment gains.”

In looking for possible tax breaks, investors first have to sort out winners and losers and also identify which investments can qualify for short-term and long-term treatment.

Sorting Out Long-term, Short-term

Investments held for 12 months or less are considered short-term; those held for more than 12 months are long-term. In figuring taxes, any short-term gains first are matched with any short-term losses and long-term gains with long-term losses. Then, net short-term gain or loss is weighed against net long-term gain or loss.

A net short-term gain is taxed as ordinary income. For taxpayers in the 25-percent and higher brackets, long-term gains are generally taxed at 15 percent; for those in the 15-percent or 10-percent brackets, long-term gains are taxed at zero percent. However, if someone’s ordinary income puts them in the 10- or 15-percent bracket but their capital gains push total income above the 15-bracket, only the gains below the 15-percent level benefit from the zero rate.

For example, suppose a couple who files jointly has ordinary taxable income of $64,000 and long-term capital gains of $3,000. The top of the 15-percent bracket for 2008 was $65,100. So $1,100 of these gains would enjoy the zero-percent rate; the remaining $1,900 would be taxed at 15 percent.

If you’ve bought various amounts of shares of a given stock at various prices over a period of time, you may have potential long-term and short-term gains, of varying amounts, depending on which lots of shares are sold.

You can specify which shares you want your broker to sell so as to reach the maximum tax advantage. If you don’t identify the specific shares to sell, though, you must use a “First-In-First-Out,” or FIFO rule. Suppose you buy 100 shares in a company when they were priced low and another 100 after the share price rises dramatically. At a later time, the stock price declines to a bit above its original level. If you tell your broker to sell 100 of your shares but don’t specify which, you will show a capital gain; if you designate the high-priced shares as the ones to be sold, you’ll show a loss.

For mutual funds, investors can choose two additional rules for figuring their gains or losses. Both use the average cost of the shares in a fund. One method uses a single average price for all the shares, the other divides the shares into short-term and long-term holdings and calculates an average price for each group.

“Different methods produce different results,” Luscombe observed, “but you have to make sure that your broker or mutual fund company can accommodate the method you choose. Also, once you use one of the averaging methods for mutual fund shares, you can’t switch to the FIFO or specific-shares method for the same fund without IRS permission.”

Plotting a Strategy

If, after netting capital gains and losses, you are left with capital losses, you can use them to offset up to $3,000 in ordinary income – $1,500 in ordinary income if you are married but filing a separate return. Losses in excess of those amounts can be “carried over” to offset capital gains in future tax years.

“The $3,000 amount hasn’t changed for decades,” Luscombe observed. “It’s one of the relatively few parts of the tax code that isn’t indexed for inflation. Bills to increase the allowable amount have been introduced, but so far none has come close to passage.”

If you have realized losses and paper short-term gains, you should consider two possibilities. One is to realize gains to the extent that they can be offset by losses. The other is to hold on to the short-term assets until they qualify for long-term treatment next year. The losses then are used to reduce income taxed at ordinary rates up to the $3,000 limit.

“Your first concern should be to use losses to offset gains that will be taxed at a high rate,” Luscombe noted.

If you’re one of the fortunate few with realized gains and paper losses, consider selling losers to offset $3,000 in earned income as well as your gains.

In devising a strategy, also consider your current and future tax bracket.

“If you’re likely to move into or out of the 15-percent bracket, you’ll want to consider timing gains to take advantage of the lowest possible rates,” Luscombe said.

A Rule That Can Wash Out Tax Advantages

There’s a special wrinkle in the tax law that affects investors with depressed portfolios. Suppose you currently have a paper loss in the stock of XYZ Inc., but you think it will rebound.

Your paper loss in XYZ does you no good. But can you sell shares now, to realize the loss, and buy the shares back again, so that you’ll profit if XYZ rises in the future?

You can – almost – but you have to contend with what’s known as the “wash sale” rule. This rule prevents you from realizing a capital loss if you engage in buy and sell transactions of “substantially identical” assets within 30 days of each other.

But you can buy another lot of XYZ today, wait 31 days and sell your original XYZ shares. This technique is called “doubling down.” It gives you the opportunity to realize all of XYZ’s gains at a later date, but it makes the size of your loss in the stock uncertain until you actually sell. The other alternative is to sell your shares today and wait 31 days to buy a new lot at, what you hope, is still a reasonable price.

Gains and Losses on Your Home and Collectibles

In 2008, many people saw not only their stock portfolios but also their homes and even expensive artwork decline in value. As capital assets, sales of these items can play into capital gains calculations, but they are subject to special rules.

In many circumstances, individuals can exclude $250,000 of gains on the sale of their home from their income; joint filers can exclude up to $500,000. Any excess over the excluded amount is then subject to tax as a long-term capital gain, and that gain can be offset by capital losses.

Unfortunately, a loss on the sale of your home is classified as a “personal” loss, and it cannot be used to offset either capital gains or ordinary income.

“It’s not a two-way street,” Luscombe said.

Gains and losses on collectibles, such as works of art, coins and stamps, also get special treatment. Net long-term capital gains on collectibles are taxed at 28 percent or the taxpayer’s ordinary income rate, whichever is lower. However, under the netting rules, net short-term capital losses may offset net long-term gains from collectibles before offsetting net long-term capital gains from other assets taxed at lower rates. Net long-term capital losses from collectibles may offset other capital gains and ordinary income up to $3,000.

“The tax code gives taxpayers a break by allowing capital losses to offset 28-percent gains before offsetting 15-percent gains,” Luscombe noted.

About CCH, a Wolters Kluwer business

CCH, a Wolters Kluwer business (CCHGroup.com) is a leading provider of tax, accounting and audit information, software and services. It has served tax, accounting and business professionals since 1913. Among its market-leading products are The ProSystem fx® Office, CCH® TeamMate, CorpSystem®, CCH® Tax Research NetWork™, Accounting Research Manager® and the U.S. Master Tax Guide®. CCH is based in Riverwoods, Ill.

Wolters Kluwer is a leading global information services and publishing company. The company provides products and services globally for professionals in the health, tax, accounting, corporate, financial services, legal and regulatory sectors. Wolters Kluwer has annual revenues (2007) of €3.4 billion ($4.8 billion), maintains operations in over 33 countries across Europe, North America and Asia Pacific and employs approximately 19,500 people worldwide. Wolters Kluwer is headquartered in Amsterdam, the Netherlands. For more information, visit www.wolterskluwer.com.

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