How to Head Off a Tax Bite

The top tax rate on capital gains went up this year. If you and your advisor are smart with tax planning, you don’t have to pay this rate at all.

Should you make more than $400,000, and you sell an asset that increased in value, the tax on your gains is now 20%, up from 15% last year. This includes securities that rise in price, dividends from stocks and profit from a home. If you make between $36,250 and $400,000, the tax is 15% and if you make less than that, you don’t have to pay taxes on capital gains.

By creatively repositioning assets, a process called tax-loss harvesting, you can not only avoid current capital gains taxes, but also offset future capital gains.

I did this for one of my clients recently. In 2012, one of my newest clients told me that he had to sell his holding in a large restaurant chain due to a takeover. He had no choice but to recognize $20,000 of long-term gains and had to pay approximately $8,000 in tax. Through tax-loss harvesting, I completely eliminated his capital gains tax liability and found another $1,000 of losses for him to offset future gains.

Tax-loss harvesting is intentionally selling an investment at a loss to offset current or future capital gains. If you do it properly, it is a powerful technique to significantly lower your taxable income. Of course, everyone prefers to see their stock portfolios rise in value, even if that means paying tax on capital gains. But as we witnessed in 2008-2009, portfolios can also incur losses. No one likes to see their investments go down in value, but you can make use of such losses.

Current Internal Revenue Service rules limit capital loss deductions to only $3,000 annually. The good news is that you can carry over losses greater than $3,000 for use in future years.

For example, if you purchased an investment for $20,000 and sold it for $10,000, you can only deduct $3,000 each year from your taxable income. The remaining $7,000 carries over to future years to offset future capital gains. So if the following year you sell another investment for a $15,000 capital gain, you pay tax on only $8,000.

In our situation, my client was forced to sell his position at a gain because of the takeover. Not all of the investments my client made were profitable, though. While his restaurant holding did very well, he had some stocks that lost money.

I found which of his investments had unrealized losses, how much unrealized losses he had and whether the total unrealized losses were sufficient to offset his $20,000 of gains. By combing through each of his holdings, I found $21,000 of unrealized losses among several investments. I sold those investments to recognize the $21,000 of loss and offset his gain of $20,000.

The transactions nearly zeroed themselves out and in fact resulted in my client having an additional $1,000 loss he could use against future gains. Those losses were there already. If he doesn’t realize those losses this year, he gets an $8,000 tax bill, atop the $21,000 paper loss.

No one likes to lose money on investments, but when the markets are as volatile as they are, give yourself the gift that keeps on giving – harvest your losses. Tax loss harvesting is only relevant in your taxable accounts, not in your individual retirement accounts, 401(k)s or other tax-efficient investment vehicles. Each person’s tax situation is different so you should definitely consult your financial and tax advisors before you try this.  

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Ara Oghoorian, CFP, CFA, is the founder and president of ACap Asset Management in Los Angeles, Calif. A fee-only investment management firm, it specializes in helping doctors and physicians make sound financial decisions. Contact Ara at aoghoorian@acapam.com or on the Web at www.acapam.com
 

 

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