Investors are routinely told to scour their portfolios for losers to sell late in the year, in time to harvest tax losses to offset gains and income.
But what if your loser is ready for a comeback? Can you sell it to get the tax loss and then buy it back to enjoy the rebound?
You can sell, but if you buy the same security within 30 days the tax loss will be disallowed under the “wash sale rule.” Uncle Sam is happy to accommodate investors who’ve suffered losses, but he’s not going to be played for a chump.
Harvesting tax losses is a valuable tool in managing a portfolio. Sell your block of XYZ shares for $5,000 less than you’d paid, and you can wipe out tax on a $5,000 gain for one or more winners you have sold. Assuming a long-term capital gains tax rate of 15%, this would save you $750 in taxes.
If you had not sold any winners, you could use the loss to reduce your ordinary income by up to $3,000 a year. A taxpayer in the 20% federal income tax bracket would thus save $600.
And the unused loss, $2,000 in this case, could be “carried forward” and used to offset capital gains or income next year or later. The loss carried forward would have to be used to offset any capital gains before it could be applied against income.
But an investment should not be sold just because it has brought a loss. At the lower price under current conditions, it might be a bargain. Generally, long-term investors should not move in and out of the market, so a money-losing investment with a promising future should be held.
Still, the chance to book a loss is tempting, and the tax benefit is a sure thing while future gains from keeping the investment are not. Unless you think the investment will jump in the next 30 days, it might be worth the risk of missing a rebound by sitting on the sidelines for 30 days to realize the loss.
The wash sale rule actually applies to purchases of the same or “substantially identical” securities 30 days before or after the sale.
Substantially identical means, for example, that if you sold the Vanguard 500 index fund (Stock Quote: VFINX) and immediately bought Spyders (Stock Quote: SPY), you would not be allowed to claim the Vanguard loss, since both products are index-style investments in the Standard & Poor’s 500.
The wash sale rule would also apply if you sold a security and invested in options to purchase the same security, or one that was substantially identical.
But if you thought the rebound would involve a particular industry, you could avoid the wash sale rule by purchasing a stock or other investment likely to behave like the one you sold. You could sell Ford (Stock Quote: F) and buy Toyota (Stock Quote: TM), for instance.
For complete details on the wash sale rule, look at IRS Publication 550. Use the BankingMyWay Savings, Taxes and Inflation Calculator to see how taxes can reduce your investment returns.