What capital gains?
If you’re one of the many investors who have racked up major losses in your portfolio this year, it may not be as bad as you think. With a little tax planning before the year is up you can make these losses work in your favor.
“Now is the time for people to be looking at how their portfolio is invested and whether it’s time to redistribute some funds,” says Michael Cecere, client service partner and CPA with Gray Gray & Gray LLP.
Though Cecere does not advocate basing investment moves on tax considerations, he says, "if you think it’s the right time to sell or because you need the funds, there are opportunities to take advantage of from a tax perspective.”
All Is Not Losses
“If you have incurred a lot of losses and want to cleanup your portfolio, you should see what [capital gains] you have and what you can pit together,” says Steven J. Elliott, CPA and master personal financial planner and senior tax associate with Janover Rubinroit.
For tax purposes, you can offset as many capital gains with losses as you want. If you have losses that exceed capital gains, you can deduct up to $3,000 each year. For example, if you realize $10,000 in losses and $5,000 in gains, you are left with $5,000 in losses, $3,000 of which you can deduct against ordinary income.
But even though you can only deduct up to $3,000 a year, losses can be carried forward, making them very helpful in the future.
Many investors whose portfolios are ridden with losses may not see this as a benefit because they don’t think they have much in the way of capital gains to offset the losses. However, for investors who own shares of mutual funds that may not necessarily be the case.
Peter Maniscalco, a CPA with Peter A. Maniscalco & Associates says he has been seeing a lot of mutual funds sending out notices that there will be a big capital gains distribution. "In some cases, these distributions are as high as 10% of the value that a person has invested," says Maniscalco.
That's because when a fund needs to generate enough cash to pay investors that are exiting the fund, it typically sells securities within the fund that have appreciated and thus generated capital gains. Those capital gains distributions are passed on to the shareholders. So even if the net asset value of the fund has gone down, you can still get taxed on those gains. (Note: this does not apply to mutual funds in 401(k) plans or IRAs as there is no tax effect there.)
According to Maniscalco, if a fund is making significant capital gains distributions, you may want to consider selling some other investments in your portfolio that have accrued losses to offset those gains.
But keep this in mind: A rule known as the wash-sale rules prohibits investors from taking a loss on a stock or mutual fund investment if you repurchase the same investment within 30 days. This means that if you still like the security or fund that you need to sell because you expect it will eventually come back, you will have to wait 30 days, during which time your money is sitting on the sideline.
Regulations And Politics
That’s why a better alternative, according to Maniscalco, is to sell the losing security and then invest in a security or fund in a similar asset class. For instance, if you want to sell a growth and income fund to take the loss, buy a similar growth and income fund so that when that group comes back into favor you’ll still have exposure to that area, he said.
There’s one more thing to consider when it comes to managing gains and losses in your portfolio. While many investors are wondering whether now is the time to sell securities that have racked up big losses, some are also considering whether now is a good time to sell securities with large embedded gains in anticipation of a hike on capital gains taxes next year.
Cecere, of Gray Gray & Gray, says “the perception that a lot of people have is that the [capital gains] rates will go through the roof," based on the campaign pledge of President-elect Barack Obama, who wants to eliminate Bush administration tax cuts.
Cecere urges caution, saying taking rates from 15% to 20% “is an increase but it’s not the dramatic increase that would force someone to say, ‘I’m going to sell now to be taxed at the lower rate.’”
“It is a bit of a waiting game and a bit of a gamble,” says Cecere, especially given the growing speculation that the economic slowdown now has Obama leaning toward letting the lower rated expire in 2010 as scheduled rather than repealing them beforehand.
Managing gains and losses can be tricky business, but if done properly and before the year is up, for many people the benefits can be significant.