Fine-Tuning Capital Gains and Losses

Year-end has historically been a good time to plan tax savings by carefully structuring capital gains and losses.  Conventional wisdom has always been to minimize gains by selling “losers” to offset gains from “winners,” and, where possible, generating the maximum allowable $3,000 capital loss for the year.

Long-term capital losses offset long-term capital gains before they offset short-term capital gains. Similarly, short-term capital losses offset short-term capital gains before they offset long-term capital gains. (“Long-term” means that the stock or property has been held over one year.) Keep in mind that 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 or AGI.  Individuals are subject to federal income tax at a rate as high as 35% on short-term capital gains and ordinary income. Long-term capital gains are generally taxed at a maximum rate of 15%.

All of this means that having long-term capital losses offset long-term capital gains should be avoided where possible, since those losses will be more valuable if they are used to offset short-term capital gains or ordinary income. Avoiding this requires making sure that the long-term capital losses are not taken in the same year as the long-term capital gains. However, this is not just a tax issue; investment factors also need to be considered. It would not be wise to defer recognizing gain until the following year if there is too much risk that the property’s value will decline before it can be sold. Similarly, one wouldn't want to risk increasing a loss on property that is expected to continue declining in value by deferring its sale 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, a taxpayer should take steps to prevent those losses from offsetting those gains.

However, historical tax-planning logic may not apply this year for the following reasons:

• Increasing Capital Gains Rates - The special long-term capital gains rates that have been in effect since 2003 sunset (end) at the end of 2010 and return to the pre-2003 levels of 10% and 20%! These federal rates are currently 0% for taxpayers in the 15% and lower tax brackets, and 15% for those in higher tax brackets. Although only talk up to this point, proposals have been floated to raise the rate to 20% as early as 2010, plus tack on a 4.5% surtax for the wealthiest taxpayers.  Individuals with large, long-term capital gains in their investment portfolios might consider selling those holdings to take their gains now at the lower tax rates.  The good news here is that the wash sale rules do not apply to assets sold at a gain. So if you like a stock, you are free to buy it back right away. If your state doesn’t have a lower tax rate on capital gains, then the additional state tax you’d pay from selling profitable capital assets will need to be weighed against the federal tax you’d potentially save when deciding whether to make tax sales before year-end.

• Raising Marginal Tax Rates –With record deficits, taxes have to go up—campaign promises notwithstanding—and we can expect that to happen in the near future.  The only questions are when, how much, and for whom?  Conventional wisdom has always been to defer income, but with a potential for increased taxes, it may be appropriate to consider accelerating income to take advantage of the current lower tax rates.

It may be in your best interest to review your current year tax strategy with an eye to the future to maximize your benefits from gains or losses associated with capital assets.  Please call this office for assistance. 

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