For nearly two decades, investors have been riding a stock market roller coaster. The late 1990s tech stock boom turned into a bust in the early years of this century, as the Dow Jones Total Stock Market Index fell by approximately 45%. After a real estate-led recovery pushed stocks to new highs, a real estate collapse dropped that index more than 50% from 2007 to 2008. Since then, the index has nearly tripled; as of this writing, U.S. stocks are near record levels.
Despite this seeming up-and-down symmetry, stock market gains and losses are not taxed equally. When you file your annual income tax return, all of your net capital gains are taxed. That’s true whether your gains are $1,000 or $100,000. Moreover, you will owe tax on gains taken by your mutual funds, even if you have all of your gains reinvested (gains in tax-deferred retirement accounts aren’t currently taxed).
Example 1: Ann Baldwin executes trades in her taxable brokerage account in 2018 and reports $50,000 of long-term capital gains and no capital losses. Ann also owns mutual funds in that account, which report $10,000 of long-term capital gain distributions this year, which Ann has reinvested. Ann owes tax on the entire $60,000 gain.
Example 2: Carl Davis executes trades in his taxable investment account during the year and reports $50,000 of capital losses and no capital gains. Carl also owns mutual funds in his taxable account that report $10,000 of long-term capital gain distributions this year, which he has reinvested.
In example 2, Carl reports a net loss of $40,000 for the year (netting the $50,000 loss and the $10,000 fund distribution). However, the maximum annual net capital loss deduction is limited to $3,000 per year on a single or joint income tax return.
Therefore, Mr. Davis can deduct only $3,000 of his $40,000 net capital loss from the income on his 2018 tax return. The remaining $37,000 of his capital losses must be carried over (a.k.a., capital loss carryover), for use in the future. Such losses can offset net capital gains in future years, dollar for dollar. Loss carryovers in excess of future net capital gains can be deducted against other income, up to $3,000 annually.
Example 3: Carl carries over a $37,000 net capital loss from 2018. In 2019, he has a net capital gain of $11,000. Carl can completely offset that gain with his loss carryover, so he owes no tax on his gains that year. He still has a net loss of $26,000 ($37,000 less $11,000), so he can deduct an additional $3,000 from other income on his 2019 tax return. Going into 2020, Carl has a $23,000 net capital loss carryover.
Example 4: In 2020, Carl Davis executes no taxable trades in his taxable brokerage account. On his annual tax return, he can take another $3,000 net capital loss deduction against his other income. Going into 2021, Carl has a $20,000 net capital loss carryover remaining.
As shown in the preceding examples, capital losses can save taxes, now or in the future.
It may make sense to use loss carryovers as soon as possible. If you have carryover losses from the 2008 financial crises or earlier, the current bull market in stocks may provide opportunities to use them up.
Example 5: Erica Foster has a total of $120,000 in loss carryovers, primarily from 2000-2008. Currently, most of the stocks Erica owns have gained value since the time she purchased them. Erica is concerned that her exposure to the stock market is too high. Thus, she sells the stocks of seven (7) different companies she owns, for a total gain of $105,000. Using her capital loss carryovers, Erica will report no taxable gains in the current year. She will still have $15,000 in carryover losses ($120,000 less $105,000), so Erica can deduct $3,000 on her 2018 tax return. As a result, Ms. Foster’s net capital loss carryover to 2019 will be $12,000.
Suppose in our example, Erica is extremely concerned about a stock market correction (i.e., downturn). In an effort to reduce her risk of loss from another crash, she decides to increase her holdings of bonds, commodities, and cash by selling a sizeable portion of her equities.
Liquidating stocks is not the only move you can make when you use up loss carryovers.
Example 6: Erica takes gains on seven stocks to use up most of her loss carryovers, as explained in example 5. In this scenario, though, Erica is moderately worried about a future market crash. She uses the money from selling three of her stocks to buy bonds and increase cash, reducing her stocks.
The money from selling the other four stocks is used the next day to buy back those stocks, which Erica believes have excellent future prospects. This buyback will raise her basis in those stocks, reducing the taxable gain or increasing the capital loss on a future sale.
Suppose Erica invested $25,000 in ABC Corp. in 2009. This year, she sells those shares for $40,000. As explained, Erica will owe no tax on the $15,000 gain because of her loss carryovers. After the buyback, Erica will have a $40,000 basis in ABC, not a $25,000 basis, so she’ll have improved her tax position without paying any tax.
If Erica were to sell shares at a loss and buy them back any time in the next 30 days, the wash sale rules would prevent her from using the loss on her tax return. The was sale rules don’t apply to capital gains, though, so Erica is allowed to boost her basis in this manner. My office can help determine….