Now's the Time to Study Your Losers Before Ditching Them for Tax Breaks

Editor's note: In place of the usual Q&A, today's holiday edition of Tax Forum examines year-end tax-loss selling.

Don't create buying opportunities for people like Cramer.

Selling a stock just because it has tanked and you want to make your tax return look pretty just sends money managers and bargain-hunters on a shopping spree.

That's because every time you sell a share, it puts pressure on the stock price. And if the company's fundamentals still are strong, the stock becomes more of a bargain.

Granted, if there's dead wood in your portfolio, now is the time to get rid of it. And chances are, you have some stocks that are under water. Of the 1,500 stocks in the S&P 500, the S&P MidCap 400 and the S&P SmallCap 600 indices, almost 57% are down on the year. (See this recent story for more details.)

Year-End Tax Savings Checklist

But you need to do some homework before pruning your portfolio. Don't sell a stock if it has a long track record of strong earnings and sales growth, if it operates in an attractive, growing industry and if it has strengths relative to its competition.

"Don't let the tax tail wag the dog," says Bill Fleming, director of personal financial services for PricewaterhouseCoopers in Hartford, Conn.

If you are intent on selling some of your holdings because, fundamentally, they are losers, here are some things to remember.

Capital-Gains Refresher

Your capital gains offset your capital losses, and vice versa, but there's a pecking order.

For stocks held at least 12 months and a day, any gains at the time of sale will be taxed at the long-term preferential rate of 20% (or 10% if you are in the 15% ordinary income tax bracket).

Any gains generated from sales of securities held less than a year will be taxed at your ordinary income tax rate. That could be 15%, 28%, 31%, 36% or 39.6%, depending on your income.

Short-term gains and losses are reported separately from long-term gains and losses. Each type also is netted separately. Only then is the net long-term gain or loss combined with the net short-term gain or loss to create your final capital gain/loss number. That end result will determine the tax rate that's applied. (Schedule D -- Capital Gains and Losses will walk you through these calculations.)

When the final net number is a loss, you can only take up to $3,000 ($1,500 if you're married and filing separately) of losses on your current year's tax return. The balance can be carried forward for an unlimited number of years until the loss is exhausted.

Note that the carry-forward amount retains its short- or long-term status, according to Section 1212(b)(1) of the tax code. So if you're carrying a short-term loss forward to 2000, it won't turn into a long-term loss in the new millennium.

Identify Specific Lots Sold

Rather than selling your newest or oldest shares first, you can designate specific lots to sell. That way you can unload your highest-cost lots first.

It's very important that you inform your broker, in writing, if you're identifying specific lots. If you've previously sold shares by some other method (first-in, first-out, for example), it's OK to switch to specific-lot identification. You don't have to file anything with the Internal Revenue Service.

Note that the rules are different for mutual funds. If you've been selling shares on a first-in, first-out basis, or some other basis, you can't switch to specific-lot identification for your next sale. You can, however, use different selling methods for different funds.

Be Wary of the Wash-Sale Rule

You've got to be cognizant of the wash-sale rule when buying and selling securities. Remember, you can't deduct a loss on your tax return for the sale of a security if you acquire a "substantially identical" security 30 days before or after the sale.

There are two ways to get around that.

First, you can double up on your favorite holding to take advantage of the stock's temporary setback. Here's how.

Your darling stock has tanked over the past few months, but you believe in it and you don't want to give it up. At the same time, you need a tax loss to offset some capital gains.

So double your current position. Let's assume that a few months ago you purchased 100 shares at $100, and the price has since fallen to $60. To take advantage of this loss, buy 100 more shares today.

Wait until the 31st day after the second purchase, then sell your original lot of shares that have a cost basis of $100. Assuming the stock has held around $60, you now can claim a $40 loss per share on your tax return.

Be sure to notify your broker that you've chosen to sell the first lot of shares. Make sure there's some notation to that effect on your brokerage statement. Otherwise, the sale might be seen as a last-in-first-out sale. More importantly, keep this documentation in case Uncle Sam asks for proof one day.

Nov. 30, the Tuesday after Thanksgiving, is the last day to double up for 1999.

The second way to avoid the wash-sale rule is to sell the loser and buy a holding in the same industry.

For instance, if you've been holding TJX (TJX Quote), the company that operates T.J. Maxx and Marshalls stores, since early January, you're down around 20%. Perhaps you want to take the loss but keep the retail exposure in your portfolio.

Sell TJX and buy an equal amount of Limited (LTD Quote). It's up about 40% over the same period. You wind up with the capital loss on your tax return and your portfolio still has a position in the retail sector.