Thursday, July 26, 2012

Stock vs Bonds, tax comparison, Part 2

In this post, I'll write about tax implications of losses in investment.

As I mentioned previously, the IRS is actually pretty fair when it comes to capital gains / losses. What I mean is that it taxes you when you make money, and it refunds you when you lose money.

In case you still haven't noticed a theme with IRS and their enormous tax code, let me give you a hint, "two" lurks around everywhere. Yes, losses come in two types, too. And no, this is not going to be the end of "two"-types streak.

First type is "short-term" capital loss. These are losses due to selling shares before holding them for one year. The second type is "long-term" capital loss, originating from selling shares that have been held by you for more than a year. And when I refer to capital loss, I always mean realized losses, you need to have sold the shares for the losses to be realized. 

As you probably noticed, they are the exact mirror of ST and LT capital gains. When it comes to tax credits, the rules are closely tied to the ST and LT characteristics as well.

ST capital losses incurred in a year can be used to offset ST capital gains, if there is any excess, you can then use it to offset LT capital gains. In case you're a super loser (in the investment sense), and you lost so much in ST investment, you can then use the rest to offset your your net LT capital gains (defined by LT capital gain - LT capital loss). Now in the hyper loser case, you can then use what's left of your current year's ST loss to offset ordinary income, up to 3k. If you qualify for ULTRA loser, i.e. you exceed 3k a year, you get to carry the losses over to the next tax year. Combined with the new losses, you repeat the steps again.

LT capital losses work much the same way as ST capital losses. The only difference is that they are used to offset LT capital gains first, then net ST capital gain, then ordinary income.

Now people have noticed a potential loophole here. Imagine you bought Stock A for 10k, before the end of the tax year, it has fallen to 5k. (I know, tough luck). You could potentially sell the stock and incur a 5k realized ST capital loss. What you could then do, is to buy it back using 5k. Sure, you lost probably 7 dollars of trading fee, but assuming a combined federal and state tax rate of 30%, you saved 5k * 0.3 = 1.5k of tax money. Of course you'll end up paying more tax later when the stock's price goes up, but you essentially have 1.5k for free until you sell the stock at a gain. And if you have those 1.5k invested, you probably end up with more than 1.5k by the time you have to pay the tax on your gains by selling Stock A. Feels like free money, huh?

Well it doesn't work, sorry to burst your bubble. What I just described there is called a "wash sale", and it is a practice forbidden by IRS. Wash sale is defined as selling and buying investments that are "substantially the same" within 30 days. The window is actually more like 60 days, because if you buy something in July 1st, you couldn't sell between June 1st and July 30th. Well, I'm being sloppy here, yes you can "sell" or "buy", but you just can't take tax credits for your losses. Of course, the IRS being "fair", it also means that you don't incur capital gains in the same window.

Some people unintentionally introduce wash sales to their portfolio when the stock market is very volatile and one tries to chase performance and stop loss. This is fine, just pay attention to the tax filing, do not blindly include your ST capital losses if your financial institution does not take wash sale related regulations into account. Because the IRS may find you later with hefty fines and other undesirable punishments.

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