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Maybe it is time to make lemonade from equity lemons – and maybe not

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2013 has been a great year for most equities, but not all. If you own any stocks that are worth less than you paid for them, there is still time to harvest those losses and use them to reduce the 2013 tax bite from capital gains.

Every year, the taxman lets us offset capital gains with capital losses and up to $3,000 of ordinary income, if the losses exceed the gains. If the losses exceed both capital gains and $3,000 of ordinary income, they will remain on the IRS books to cover future annual gains and income – until they are used up.

Some caveats

In order to qualify for a capital loss, the equities must be held in taxable accounts, i.e. not qualified retirement accounts like IRAs or 401Ks.

The sales of equities within qualified accounts do not trigger tax events, nor do they create a taxable capital gain or loss in the years of the transactions or later.

However, if you sell equities in an IRA or 401K and remove the proceeds from the protected account, a tax event is created in the year the money is withdrawn. In that case, the proceeds are treated as ordinary income (which always happens with an IRA or 401K withdrawal – except Roth IRAs) on your tax return, and depending on your circumstances vis-à-vis the regulations, may also subject you to penalties.

Harvesting losses and repurchasing the same equity

If you plan to repurchase a stock after you harvest the capital loss, be sure to wait 31 days from the sale date. If you buy back the same stock you sold at a loss within 31 days of the sale you will run afoul of the wash sale rule (see the video that accompanies this article).

Some financial advisors believe there is little reason to harvest capital losses if you plan to repurchase the stock at a lower price, because when you buy back the equity your cost basis for tax purposes becomes the new purchase price. Thereafter, when you go to sell the stock at a future date you will pay greater taxes on any gains.

The logic continues, if you have no compelling reason to sell your losers, and hold them until the price rises above your original purchase price, you would have less taxes to pay on the future gain. Whereas, if you sell for a loss now, and repurchase the stock at a lower price, the spread will be that much greater when the stock rises over the original purchase price.

As an example: If you bought XYZ stock in a taxable account for $100 14 months ago, and it is now worth $50, and you sell with the intention of a repurchase after 31 days, you create a capital loss of $50 which can be used to offset capital gains and ordinary income on your 2013 taxes.

You wait the 31 days and the stock is still selling at $50 when you repurchase it. Your new cost basis is $50. Let us say that in three years hence the stock value increases to $150, and you decide to sell. You now have capital gains of $100 on which to pay taxes ($150 - $50). If you had held the original $100 stock instead of selling for a loss at $50 in 2013, and waited the three years and sold at $150, your capital gain would only be $50 on which taxes would be due ($150-$100).

If tax policy changes for the worst over the next three years, and let us speculate that capital gains are treated as ordinary income, you will likely pay much more taxes on the repurchase scenario (the $100 gain). It would have been far better to hold the original stock until the recovery and subsequent gain.

Of course, if tax policy changes to favor capital gains, you would be better off with the repurchase scenario – but what do you think are the chances that short-term future policy will favor capital gains investors?

Happy holidays!

Before you act on any financial advice that you read here or elsewhere, be sure to seek the counsel of your financial, and/or tax adviser. There are many roads to financial prosperity, get to know all your options.



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