Booyah Breakdown: Tax Twists
Tracy Byrnes
11/18/06 - 09:48 AM EST
Cramer does a ton of buying and selling. And while he says you shouldn't worry about the tax implications, there's a little arcane tax rule that rears its ugly head when you buy and sell too quickly.
So before you start doing your year-end tax-loss selling, analyze your holdings.
Clearly, you should sell the stuff that means nothing to you. Take the loss on your tax return and chalk the mess up to experience.
But what if you've got losers in your portfolio that you still believe in?
Take
Ford(F). Say you bought the stock back in January 2004, when it was trading around $16. These days, it's hovering around $8.
But say you're a believer in the good ol' American company and believe a turnaround is coming. Though it would be nice to use that loss on your tax return to offset the other gains you made following Cramer's advice, you really want to stay in the stock.
Well there's a great tactic that will allow you to do both. There are two catches though: you have to heed the wash-sale rule, and you have to complete this trade by Nov. 28.
First, let's fully understand the wash-sale rule.
Think of a wash sale this way: You're at the racetrack, and you win $500 on your favorite horse in the third race. You believe you're on a roll, so you bet again. But you lose it all in the eighth race. The day turns out to be a wash, and you go home financially unaffected. (Your emotional situation is an entirely different story.)
The wash-sale rule applies this concept to securities. If you buy a stock, sell it at a loss and then buy it back, on paper you're in the exact position you started. You're still holding the same stock that you started out with.
The problem is you generated a tax loss in the process. And the government doesn't think you should be able to deduct that loss on your tax return if you haven't really altered your position.
The official jargon in the tax code says that if you sell a security at a loss, you can't deduct the loss on your tax return if you acquired a "substantially identical" security 30 days before or after the sale. Translation: If you buy a stock on Monday and sell it at a loss on Tuesday, the wash sale rule says you can't claim that loss on your tax
return if you buy back the same stock within 30 days.
Of course, if you just can't wait 30 days to buy the shares back, there is a way to claim the loss: You can add the loss to the basis of the repurchased security.
Let's say you buy a share at $10, sell it at $5, and buy it back within 30 days at $6. You can add the original $5 loss to your new cost basis, which is now $11 ($6 + $5). If the stock rises and then you sell, let's say at $12, your taxable gain is only $1. So by repurchasing before the 30 days are up, you've cut into your upside potential.
There are exceptions to the wash-sale rule. It doesn't apply to dealers. And if you're an individual who elects trader status -- meaning you make your living by sitting in your office trading securities -- and you mark-to-market your trades (that is, value
your portfolio at year-end as if you were selling it), you're excused from the rule.
Everyone else, read on.
Substantially Identical?
So back to the tax jargon. The rule says you can't deduct the loss on your tax return
if you acquired a "substantially identical" security 30 days before or after the sale.
Unfortunately, the tax code doesn't really offer up a good definition, so it's kind of in the eye
of the beholder. But we'll try to help with some examples.
Shares of the same stock in the same company are, obviously, substantially identical (though preferred stock is not substantially identical to common stock). Beyond that, the best way to
illustrate the "substantially identical" rule is to go directly to some strategies for avoiding the wash-sale rule:
Buy stock in a similar company. The stock of one company is generally not substantially identical to the stock of another company in the same industry. So, in our example, if you own Ford but want to need some auto exposure, consider selling your Ford stock and buying GM (GM) instead.
Trade a sinking company for its merger partner. If your favorite stock is in the process of a merger but has recently tanked, here's a way to
stay in your stock but still take the tax loss. Let's say you're long the buyer in the merger and the stock is down a lot, but you still like the company. Sell it and buy stock in the target company.
The rules say the stocks of two merger partners are not substantially identical as long as there's a contingency that still has to be satisfied before the merger goes through. The yardstick here: Any trades made prior to shareholders' approval of the merger should be safe.
On the options front, the IRS has never actually opined on when one option is substantially identical to another. So we must go with conventional wisdom. That said, as long as you vary the expiration date, you're okay. To be even safer, buy options with different strike and expiration dates.
As far as other investments, it's pretty difficult to flunk the wash-sale test with mutual funds. Unless you buy back the same shares in the fund you just sold, it's almost impossible for one fund to be substantially
identical to another. So you're effectively immune.
And remember, if you trade in your IRA, 401(k) or any other tax-deferred account, you don't have to worry about the wash sale. And in most circumstances, you can sell a stock in your taxable account and buy it back in your tax-deferred account without the wash sale rearing its nasty head.
Double Dipping
We've already gone over how to avoid the wash-sale rule by buying similar companies or a company's merger partners. But what if you really want to keep that stock?
Let's say you own 100 shares of Ford and you're in the hole $8 a share. But you love it, so before you do anything, go buy 100 more shares.
Now you've doubled your position and are still in the game. Then, wait until the 31st day from the purchase of your second lot of shares and sell the original losers to get the tax loss on your return.
(On the administrative side: Be sure to tell your broker that you've chosen to sell the first lot of shares and make sure there's some reference to that on your statement. If you don't, the sale might be seen as a last-in, first-out sale, and that would defeat the purpose.)
The upside is that now you can claim the $500 loss on your return without violating the 31-day window policy, and you never had to give up your position in the stock. The downside is that you have to fork over more money to buy the second lot. You also run the risk that the stock
could fall even further over the next month, and then you've got, well, "double" trouble.
Nov. 28 is the last day you can "double up" for 2006. If you're considering it, get it done quickly.
So before the year's end, go through your portfolio and decide which stocks are worth keeping and which should be sold. And if you have a deep attachment to some of your losers, consider doubling
up so that your tax return can benefit from your portfolio's pain.
