Capital Gains and Losses - This Year, Get it Right!

In a year in which portfolios have been decimated, it is hard to find a silver lining but controlling capital gains and losses could have significant tax consequences. As the market has declined, many investors have redeemed mutual funds and the funds needed to sell investments to meet those demands. Some of these sales may have included long-term positions in which the mutual fund may have had a significant capital gain. That means, in a year in which your mutual fund may have dropped 50% in value, you may still have significant capital gains exposure.

For retirees, that is a difficult pill to swallow. Making sure you offset these gains with losses or adjusting portfolios to take advantage of losses this year against future years gains is an important consideration. Here is a primer of what the rules are.

Capital Gains and Losses

Assets owned and then sold, or otherwise disposed of, may generate a capital gain or loss. Assets that have been held longer than one year are considered 'long-term,' while on assets held for less than a year, the gain is considered short-term. The distinction is an important one.

o The maximum tax rate for long-term capital gains is 15% for both ordinary income tax and for AMT; but long-term capital gains are preference items for calculation of Minimum Tentative Tax. Be aware that, for some investors, specifically those with lower taxable income (in 2008, $32,550 for a single; $65,100 for a married couple; and $43,650 for heads of households), tax rates on capital gains would be 0%, so the harvesting of capital losses would be wasted, since they will not be taxed on their gains anyway.

o Gains and losses on assets owned less than one year are short-term. In calculating the tax on sales of assets, a taxpayer must first net the short-term gains and losses, then net the long-term gains and losses independently. Then the short-term and long-term gains/losses are netted against one another. If a net capital loss is generated, it may be used to offset up to $3,000 of ordinary income and the unused portion (if any) may be carried forward indefinitely (expiring at the death of the taxpayer). Capital losses realized on the sale of securities may also be used to offset capital gains on other classes of assets, such as real estate and vice versa on Schedule D.

o Careful planning to harvest any capital gains or losses from sales of stock or other capital assets can minimize tax on gains and maximize the tax benefit from losses. Normally, a taxpayer should try to avoid having long-term capital losses offset long-term capital gains, since those losses will be more valuable if they are used to offset short-term capital gains or ordinary income. To do this requires making sure that the long-term capital losses are not taken in the same year as the long-term capital gains.

o Planning for the offsetting of gains and losses is not just a tax issue. As is the case with most planning involving capital gains and losses, investment factors need to be considered. The decision to wait to defer a gain until the next year needs to be balanced against the risk to the value of the property, whether its value may decline before it can be sold. Similarly, a taxpayer should not risk increasing the loss on property that he expects will continue to decline in value by deferring the sale of that property until the following year.

o Additionally, a taxpayer is permitted to identify which shares are sold during a given year as part of their transaction. These are called 'Versus Purchase' sales and allow taxpayers to identify which shares are sold to best advantage from a capital gains/loss standpoint.

o A taxpayer who owns appreciated mutual funds, which may also be good candidates for sale, may wish to consider selling those funds prior to the December capital gains payment made by fund managers to shareholders. A 15% capital gains rate is much better than having to pay ordinary income tax rates, which could be as high as 35%. There are also other advanced planning techniques which can be used to help defer the payment of capital gains tax. Please consult with your tax advisor to determine which may be best for you.

Make sure you consult your tax advisor before doing anything and consider the consequences of any portfolio adjustments on your asset allocation. In a year in which investors have suffered, you need to take advantage of what you can to improve your position for this and future years.