When the value of an investment drops and you sell it or exchange it for another investment, you realize a capital loss. There will be times when you may want to intentionally realize a capital loss for tax reasons to reduce your income tax bill. Capital losses can be used to offset capital gains and possibly even to offset some ordinary income.
Why would you want to intentionally realize a capital loss?
One reason you might consider intentionally realizing capital losses is if you have incurred significant capital gains in the same tax year. Let’s say you sold a property, business, mutual fund, or stock at a large capital gain. You may be able to rearrange other investments you own to generate losses to offset your capital gains.
This strategy works best with mutual funds and exchange-traded funds. With mutual funds, by swapping one fund for another, you can realize a capital loss for tax purposes without incurring a long-term investment loss. Here’s an example of how that works:
Suppose you own a Vanguard S&P 500 index fund. You purchased it for $100,000 at the beginning of the year. The market has declined, and now it’s worth $70,000. You know that markets will recover in the long run, so you don’t want to sell it at a loss, but you want to utilize the loss for tax purposes. Instead of selling your fund and moving to cash or shifting to a different type of investment, sell it and buy another fund with a similar risk profile that tracks a different index. As the market recovers, you hope your portfolio will bounce back. Because you moved to a different investment, that loss will be considered realized, 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 from ordinary income. In many cases, you can then carry over any of those losses that exceed $3,000 to the next tax year.
Ordinary income tax rates are higher than capital gains tax rates. For someone in the 33% tax bracket, the additional capital loss of $3,000 that can be deducted from ordinary income will save them an extra $390 a year (calculated by taking the difference between the ordinary income tax rate of 33% and the capital gains tax rate of 20% and multiplying it by $3,000). For some taxpayers, it can save even more money. When using this strategy consistently, it can add up to tax savings of thousands of dollars over an investor’s lifetime.
Capital Losses with Individual Stocks
With individual stocks, this strategy does not work the same way. While you can sell existing stocks and realize a loss, you cannot replace them with a similar stock expected to perform the same way. You may get close by buying stocks in the same industry, but factors related to the companies may cause one stock to perform very differently from another.
When selling investments to realize a capital loss for tax purposes, make sure to purchase investments with different tickers. 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 denied.
Note: The wash sale rule does not apply if you sell and buy mutual funds with different tickers, even if both funds hold the same underlying securities.
There are a variety of facts and circumstances (fund holdings, security ratios, how the fund is managed, and who the manager is) that you should consider when deciding whether there are similar enough funds to trigger the wash sale rule. There is no clear rule established for wash sales concerning mutual funds, so cautious investors may want to avoid selling one fund and then buying another that tracks the same index.
Questions
Frequently Asked Questions (FAQs)
What is a wash sale?
According to IRS rules, a wash sale occurs when you sell a security and buy a substantially identical security within 30 days before or after the sale. Generally, wash sales are used to offset capital gains with capital losses.
What are capital losses?
In investing, a capital loss occurs when you sell a security for less than you paid for it. For example, if you bought one share of Apple for $175 and then sold it for $150, you would have a capital loss of $25.
Was this information helpful?
Thank you for your inquiry! Please let us know the reason for that!
Sources:
– IRS. “Topic No. 49 – Capital Gains and Capital Losses.”
– IRS. “IRS Provides Tax Inflation Adjustments for Tax Year 2022.”
– Morningstar. “Wash Sale Challenge: What Is Substantially Identical?”
– IRS. “Publication 550 – Investment Income and Expenses,” Page 56.
Source: https://www.thebalancemoney.com/how-to-realize-a-capital-loss-for-tax-reasons-2388979
Leave a Reply