Why You Would Intentionally Realize a Capital Loss?
One reason you might consider intentionally realizing capital losses would be if you were incurring large capital gains in the same tax year. Let’s say you sold a piece of real estate, a business, or a mutual fund or stock with a large capital gain. You might be able to rearrange other investment holdings you have for the purpose of generating losses to offset your capital gain. This works best with mutual funds and exchange-traded funds. With mutual funds, by exchanging one fund for another, you can realize a capital loss for tax reasons without necessarily incurring a long-term investment loss. Here’s an example of how this works:
Assume you own a Vanguard S&P 500 index fund. You bought it for $100,000 at the beginning of the year. The market went down, and it is now worth $70,000. You know in the long run the markets will recover, so you don’t want to sell it at a loss, but you would like to be able to use the loss for tax purposes.Instead of selling your fund and going to cash or moving into a different type of investment, you sell it and buy a fund with a similar risk profile that tracks a different index. As the market recovers, you hope that your portfolio will recover.Since you switched to a different investment, that $30,000 loss will be considered a realized loss and you will report it on your tax return.If your capital losses exceed your capital gains for the year, you can deduct up to $3,000 of the loss against ordinary income. In many cases, you can then carry over into the next tax year any of those losses above $3,000.
Ordinary income tax rates are higher than capital gains tax rates. For someone in the 33% tax bracket, having an additional $3,000 of capital loss that could be deducted against ordinary income would save them an extra $390 a year (calculated by taking the difference between the 33% income tax rate and the 20% capital gains tax rate and multiplying by $3,000). For some taxpayers, it can save even more. When this strategy is used consistently it can add up to multiple thousands in tax savings over an investor’s lifetime.
Capital Losses With Individual Stocks
With individual stocks, this strategy does not work in the same way. Although you can sell your existing stock, and realize the loss, you cannot easily replace it with a similar stock that would be expected to perform in the same way. You might come close by purchasing stock in the same industry, but company-specific factors may lead one stock to perform quite differently than the other. When selling investments to realize a capital loss for tax purposes, make sure you are buying investments with different ticker symbols. If you buy the same security 30 days before or after the sale, the wash-sale rule may apply and your tax loss could be disallowed. There are a variety of facts and circumstances (the fund’s holdings, the proportion of securities, how the fund is managed, and who the manager is) you should consider when deciding if two funds are similar enough to trigger a wash sale. No clear rule has been set for mutual fund wash sales, so cautious investors may want to avoid selling a fund and then buying a fund that tracks the same index.
