Tax Angles to Capital Gains and Losses

The tax rules for offsetting capital gains and losses can be confusing, even for experienced investors. Saving grace: The new 2010 Tax Relief Act extends favorable tax treatment for long-term capital gains. This latest extension lasts through 2012.

For simplicity, the following discussion is limited to capital gains and losses arising from sales of securities. (Additional special rules may apply to other capital assets such as sales of collectibles and property subject to depreciation recapture.)

Background: The rules differ for long-term gains and losses and short-term gains and losses. A gain or loss is “long-term” if you have held the security for more than one year before the sale occurs. For example, if you bought stock on July 1, 2010, and sell it at a profit on June 30, 2011, the gain is treated as a short-term gain. However, holding the stock for just two more days—until July 2, 2011—qualifies for favorable long-term capital gain.

To net your gains and losses, first place your long-term gains and long-term losses in one basket. This gives you either a net long-term gain or a net long-term loss. Next, place your short-term gains and short-term losses in another basket. This results in either a net short-term gain or a net short-term loss. Finally, combine the net long-term gain or loss with the net short-term gain or loss to arrive at an overall net capital gain or loss.

If your capital gains for the year exceed your capital losses, any net long-term gain is taxed at a maximum tax rate of 15%. For a taxpayer in either of the two lowest regular tax brackets (the 10% or 15% tax brackets), the maximum tax rate on long-term capital gain is 0%. These favorable tax rates, in addition to a comparable tax break for qualified dividends, have been extended through 2012. Without the new legislation, the tax rate on long-term capital gain would have increased to 20% (10% for low-income individuals).

Conversely, if your capital losses exceed gains, the excess net loss can be used to offset up to $3,000 of ordinary income, such as salary. Any remaining excess is carried over to future years.

Once you understand these rules, analyze your current tax situation, and act accordingly. For example:

  • If you are currently showing a net loss, you can realize capital gains before the end of the year. The capital gains are effectively tax-free up to the amount of your losses.
  • If you are currently showing a net gain, you can realize capital losses before the end of the year. The losses effectively absorb the tax you would have had to pay on the gains.
  • If warranted, you may realize an excess loss that can offset up to $3,000 of ordinary income.

Caution: If you sell securities and buy back the same securities within 30 days, you cannot deduct the loss on your tax return. This is called the “wash sale” rule. To avoid this harsh tax result, wait at least 31 days before you reacquire the stock. Alternatively, if you believe the stock will rebound, you can “double up” your shares and sell the original shares more than 30 days later. This strategy enables you to lock in the current price without forfeiting the tax loss.