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Harvest Capital Gains and Losses in Volatile Market

Oct. 27, 2014
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By Craig W. Smalley

Learn more about Craig on NerdWallet’s Ask an Advisor

In the last month the stock market has erased most of the gains that it has made for the year. Some investors may have sold some stocks and made some money earlier this year, and others may have stepped out of a security when the market started going down, securing some gains. Maybe you have just been lucky and decided to sell the big gainers in your portfolio. You now have either a long-term or short-term capital gain that you have to pay tax on. In this article we will discuss how this might not be so bad because of the downturn of the market.

If you hold a stock for one year and one day, you are subject to long-term capital gains treatment. Long-term capital gains may be taxed three different ways. If you are a single taxpayer and your adjusted gross income (AGI) is less than $36,900, you would owe nothing on the sale of long-term securities. If you make $36,901 to $405,100, your long-term capital gains are taxed at 15%. If you make $405,101 and above, those gains are taxed at 20%. If you are filing as Head of Household and you income is below $49,400, then you wouldn’t pay capital gains tax. If you make $49,401 to $432,200 you would pay 15% on long-term capital gains. If you make $432,201 and above, you pay is 20%. Married individuals filing a joint return would pay zero capital gains tax if they make less than $73,800. If they make $73,801 up to $457,600, they would pay 15% capital gains tax. For earnings above $457,601, they would pay 20%.

If you’ve held the security for less than one year and one day, then you would pay ordinary income tax at your ordinary income tax rate on the gain. Short-term capital gains are reconciled against any short-term losses and the difference is taxable. If your losses are more than your gains, you can only take $3,000 of those losses in any one year. If you have more than $3,000 in losses, they carry forward to the next year. The same is true of long-term capital gains. They are reconciled against long-term capital losses.

Now that we have the tax rules, let’s operate within those rules. Let’s talk about harvesting gains and losses.

When preparing tax returns a few years back, it was common to see my clients with several thousands dollars in losses on their Schedule D, where short- and long-term capital gains are reported. Here is the problem with capital losses: You can only deduct $3,000 per year. If you have a capital loss of $25,000, you can only deduct $3,000 of that loss and the remaining $22,000 carries forward to the next tax year. This amount can be taken in $3,000 increments until it is used up. In our example, $3,000 of the $22,000 loss that was carried forward can be used, and $19,000 would carry forward to the next year, and so on.

However, if you had a $25,000 capital gain, you would have to report and pay tax on all $25,000. Doesn’t make sense, does it? Capital gains can only be reduced by capital losses. Using the previous example of the $22,000 capital loss carry forward, if in the next year you had a capital gain of $10,000, it would be reconciled with the capital loss, giving you a $3,000 capital loss on your tax return and $9,000 to carry forward to the next year.

Enter harvesting gains. If you are carrying forward a large capital loss, and you have a security that has gained a lot of money, and you want to sell it to take some of the gain, you could do that with minimal, if any, tax consequences. For instance say in 2013 you had a $75,000 capital loss carry forward. In 2014 you have a gain in your brokerage account of $55,000. You could sell the security and still report a $3,000 capital loss on your tax return. In short you would not pay any capital gains tax. Thus you have harvested the gain without paying capital gains. That is pretty cool right?

Harvesting a loss is a little different. Let’s say that you did not have a capital loss carry forward from the year before, but this year you have a capital gain of $75,000. However, you also have a security in your portfolio that has lost big. The capital loss is $25,000. You don’t think this security will ever come back, so you “harvest the loss” and sell the security. On your tax return you will only have $50,000 that is subject to capital gains tax.

I harvest gains and losses for my clients all the time. Your tax accountant and your financial planner should know one another and should have a good working relationship. At the end of every year, I go through my clients’ investment statements with their financial advisers, and we harvest gains and losses.

All of this sounds great, but I have one word of caution. Be careful of the Alternative Minimum Tax (AMT) when harvesting gains and losses. AMT is a ticking time bomb. It is not alternative and it certainly isn’t minimum. The best and shortest explanation of the AMT is that it is an alternate way of calculating your taxes. If you have too many preferential tax items on your tax return, you will trigger the AMT. This would be triggered on long-term capital gains because the tax you pay on them is lower than your ordinary tax bracket. Note that not all people will be subject to AMT for harvesting gains and losses, but some will. Before you implement a gain- or loss-harvesting strategy, sit with a competent tax professional to access the risks of falling into AMT.

Some people look at this market and are upset at the losses they may have incurred. I see it as an opportunity to save money in taxes.