Take Advantage of a Market Drop with Tax Loss Selling

I have written many blog posts and white papers about the importance of NOT selling stocks in a panic during a down market. When the market dips, the absolute worst thing a person can do is panic, sell their stocks at a low, and miss the recovery.

However, there is one advantage to strategically selling stocks at a loss before the New Year: it allows you to minimize your capital gains tax on stocks, mutual funds, and property. The more gains you offset, the lower your tax bill.

What is Tax Loss Selling?

Tax loss selling is the practice of selling stocks, bonds, mutual funds, and other investments at a loss to reduce your capital gains tax burden. Capital gains are the profits earned from the sale of an investment or property.

Investors can deduct up to $3,000 of losses per year and carry any remaining losses over to future years.

Capital gains are taxed differently depending on your tax bracket and the length of time you held the investment. Investments held for a year or less are considered short-term investments. Investments held for more than one year are considered long-term investments.

Generally, long-term investments are taxed at a lower rate because they are taxed as capital gains rather than ordinary income. When you select investments for tax loss selling, it’s best practice to choose the same type of investment to offset the gain (i.e., a short-term loss to offset a short-term gain; and a long-term loss to offset a long-term gain).

We can’t control the stock market, but getting Uncle Sam to subsidize a portion of your loss is one way to make lemonade out of investment lemons.

Avoid Making a “Wash Sale”

It might sound tempting to sell an investment at a loss, take the tax deduction, and then repurchase the investment to reap the benefits of a recovery. Not so fast! Unfortunately, the IRS is one step ahead of you.

You are not allowed to sell an investment at a loss for tax purposes, then repurchase that same investment (or a substantively identical one) within 30 days of the initial trade. This practice is called a “wash sale” and it is prohibited by the IRS. If your spouse or your business makes the purchase, it is still considered a wash sale.

If you are caught making a wash sale, the IRS will force you to remove the loss from your current-year tax statement, and instead add the loss to the cost basis (aka. the original value) of the newly purchased investments.

Here is an example from Investopedia that breaks down this concept:

For example, consider the case of an investor who purchased 100 shares of Microsoft for $33, sold the shares at $30, and within 30 days bought 100 shares at $32. In this case, while the loss of $300 would be disallowed by the IRS because of the wash sale rule, it can be added to the $3,200 cost of the new purchase. The new cost basis, therefore, becomes $3,500 for the 100 shares that were purchased the second time, or $35 per share.

Meet with a New Jersey Financial Planner

Tax loss selling can be complicated. An experienced financial planner can help you create a tax loss selling strategy that keeps your investment portfolio balanced and fits within your overall financial plan.

Life’s too short to worry about money. Contact us for a free initial consultation.