With taxable accounts, if you sell an investment that is up, you will have to pay capital gains tax that year. However, if you have other positions that are down in value, there is a way you can sell them and take a loss on these positions to offset your gains and end up reducing your taxes.
If you end up with more losses than gains in any year, you can carry those excess losses forward to offset gains that may occur in future years. Also, after you’ve offset all your gains with your losses, you’re allowed to use up to $3,000 of excess losses that are still left over against ordinary income each year until those losses are used up.
There is a 31-day rule, which states that if you sell an investment to take a capital loss, you can’t buy back into that investment or something identical to it for at least 31 days. However, you can always buy back into a similar investment that is not identical to the investment sold, and still claim the capital loss.
For example, say you only have 2 positions in your account for sake of simplicity. One investment is up $7,000 and the other investment is down $10,000. If we sold the investment that was up, we would trigger a $7,000 capital gain which would be taxable. However, if we then sold the investment that was down
$10,000, we would trigger a $10,000 capital loss. We could then use $7,000 of that $10,000 capital loss to offset the $7,000 of capital gain and eliminate the tax on the gain.
If we didn’t have any more capital gains, we could use the last $3,000 of capital losses to offset $3,000 of ordinary income. In essence, creating a $3,000 regular tax deduction. For a taxpayer in a 22% tax bracket the net result of using this tax strategy would be to reduce their federal income tax by $1,710. Not bad for moving a couple of small stock positions around.
Studies show the value of this tax strategy could potentially add an extra 1% or more net benefit to investment returns in a year and that number could go higher in years where the market has significant declines. For some investors, that extra return from the tax savings is enough to cover the management fees paid for professional financial planning advice.
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