Definition: Tax loss selling is the practice of selling assets that have incurred losses in order to reduce capital gains taxes. You can offset your losses against your gains, thus tax loss selling can reduce your overall tax bill. This means that even when you suffer financial losses on an investment, you may be able to use it to your advantage through tax loss selling.
How does tax loss selling work?
When you sell assets, look at your selling price and subtract your adjusted basis (the amount you paid for the asset plus some additional costs). This will determine whether you have a capital gain or a capital loss. The amount you pay in capital gains taxes depends on how long you have held the asset and your taxable income.
If you sell an investment at a loss, you can use your losses to offset capital gains on winning investments. Tax loss selling is a strategy used by investors to reduce their taxes by selling some stocks at a loss to offset capital gains. It is also referred to as tax loss harvesting or selling tax losses.
Note: If you sell an asset that you have held for less than a year, it will be treated as a short-term capital gain or loss. Profits from assets sold after holding them for more than a year may be subject to long-term capital gains taxes.
Ordinary income tax is imposed on any gains realized from short-term capital gains according to ordinary income tax brackets, which can go up to 37%. Selling an asset after holding it for more than a year will result in a long-term capital gain or loss. Long-term capital gains tax rates generally range from 0%, 15%, or 20% based on your income.
Depending on your financial situation, you may be able to use long-term capital losses to offset long-term capital gains and short-term capital losses to offset short-term capital gains. You can then use long-term capital gains and losses to offset short-term counterparts, or vice versa. If your capital losses exceed your capital gains in a given year, you can deduct a loss of up to $3,000, or $1,500 if you are married and file separately from your spouse.
Note: You can also carry forward a capital loss and use it to reduce your taxable income in future years.
Example of tax loss selling
For example, suppose you sold Stock A for $10,000 more than you paid after holding it for a year. Let’s also assume you sold Stock B after owning it for over a year, but at a loss of $6,000. Due to the tax loss selling rules, you would only owe long-term capital gains tax on $4,000 because you will offset your losses against your gains.
If instead, you sold Stock A at a loss of $10,000 and Stock B at a gain of $6,000, you would have a capital loss of $4,000. You can deduct $3,000 of the loss from your income for the year. Then you can use the remaining $1,000 to offset capital gains in a future year. Or you can carry forward the total loss of $4,000 to future tax years.
Note: Use IRS Form 8949 with Schedule D to report capital gains and losses on most assets, including stocks, bonds, and real estate.
What does this mean for individual investors?
There’s no need to worry about capital gains or tax loss selling for tax-advantaged accounts like a 401(k) or individual retirement account (IRA). This is because you earn all capital gains, dividends, and interest tax-free until you withdraw the money. For traditional accounts, the money is taxed as ordinary income when withdrawn. On the other hand, for Roth accounts, you typically won’t owe any taxes as you contributed after-tax dollars.
You may
Tax selling is most effective when using short-term losses to offset short-term gains. Using short-term losses to offset long-term gains may not be a good strategy because your tax rate on long-term gains is lower. It may be better to use short-term losses to offset ordinary income or carry them forward to another year. Discuss your options with a financial advisor to make the right decision for your situation.
If you are using tax selling, it is important to be aware of IRS rules that disallow wash sales. A wash sale occurs when you sell an investment at a loss and then buy the same investment or one considered “substantially identical” within 30 days before or after the sale. If the IRS considers the transaction a wash sale, you will not be allowed to use it to reduce your taxes.
Frequently Asked Questions (FAQs)
When is the last day for tax selling?
To take advantage of tax selling, you must sell your shares before the end of the year. For example, in 2022, the last trading day is December 30, which is the last day to sell stocks to realize losses and offset capital gains.
How do you avoid capital gains tax?
You may be liable to pay capital gains tax if you realized profits from selling an asset. The capital gains tax rate depends on how long you held the asset and your income level. While you should not try to avoid paying capital gains tax, there are strategies you can use to reduce the tax burden of capital gains tax. Tax selling is one of these strategies. If your capital losses exceed your capital gains in a given year, you can deduct a loss of up to $3,000, or $1,500 if you are married and filing separately from your spouse. If your capital losses exceed this amount, you can carry them over to future tax years.
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Sources:
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IRS. “Topic Number 409 Capital Gains and Losses.” IRS. “Publication 550 Investment Income and Expenses (Including Capital Gains and Losses),” page 59. Accessed November 3, 2021. IRS. “Instructions for Form 8949 (2020).” Accessed November 3, 2021. Securities and Exchange Commission. “Wash Sales.” IRS. “Publication 550 – Investment Income and Expenses.” Wells Fargo. “2022 Tax Planning Guide,” page 5. IRS. “Instructions for Schedule D.”
Source: https://www.thebalancemoney.com/what-is-tax-selling-5208342
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