Why You Should Love Your Stinkers
We have had quite a few emails and calls about the 9 Ways to Reduce Your Taxes attachment in the November newsletter. Most of the questions were about the “wash sale” rule typically used in selling stocks so let’s spend some more time on this important tax reduction method.
Short term capital gains/losses are gains/losses that you realize by selling an asset held less than one year and they are taxed as ordinary income just like your salary. Long term capital gains/losses are gains/losses you realize by selling an asset held longer than one year and they are taxed at 0%, 15% or 20% depending on the tax rate on your ordinary income.
The key idea is that short term losses offset or reduce short term gains and long term losses offset or reduce long term gains and then net short term losses offset net long term gains! This is huge because it means you can control your “gains” tax bill just by doing some planning in advance of your selling an asset.
Let’s do an example. Suppose you bought 100 shares of Exxon at $100/share 5 years ago and now it is $200/share. If you sell it today you have a realized gain and you will pay long term capital gains tax of $100/share or $10,000. So if you don’t know any better, you just sell your Exxon to “lock in” your profit and then the next year you give the 1099-B form from your brokerage firm with this transaction to your tax preparer who dutifully enters it in your tax return.
Here is what you could have done. Everybody has stinkers. Suppose you own a stock whose market price is below what you paid for it. So you have a loss. You could have sold 100 shares of a stinker for $100/share that you bought for $200/share. That give you a long term loss or short term loss of $100/share $10,000. Guess what the IRS says?
They say your loss on the stinker offsets your gain on Exxon dollar for dollar and you don’t owe any net tax on the Exxon sale! And if you are still in love with the stinker you only have to wait 30 days to repurchase the stinker if you want to hold it because you think it will come back up in value. This is called the Wash Sale Rule. If you repurchase the stinker earlier than 30 days after you sell it then your loss is disallowed.
This strategy has been available for decades and you may hear it referred to as tax loss selling or as harvesting tax losses. You harvest the losses so they can be applied against your gains.
I know this sounds brick simple and you would think everybody does it. But, they don’t do it and what is really irritating is that professional money managers I see my clients hire almost never do this.
Every year I see clients with $15-000 to $20,000 of capital gains on their tax returns when client is still working with a strong salary income. I ask them what is this entry doing on your tax return? What do you do with this money? They tell me they don’t need it to live on so they just reinvest it because that is what their money manager said to do. Nobody ever asked them this question before.
Think about this for a moment. Why does this happen? Because the money manager doesn’t want the client to take money out of the investment account to pay the tax bill. That would reduce the growth of the assets which the manager is paid a percentage of and would really show the client how much tax
this approach is creating. The asset managers are so neglectful they won’t even do tax loss harvesting at year end because they would have to look at the client’s portfolio and make a call to the client to explain how this can/should be done.
So contact your asset manager now so you don’t come in my office in 2017 with a form 1099-B that forces me to put a big entry on line 13 (Capital Gains) on your tax return.