As the year draws to a close, many investors are looking for ways to reduce their tax liability. One way you can reduce your taxable income is to sell losing investments and use the losses to offset some of your other investment gains, or other types of income.
Offsetting Income with Investment Losses
Your first step is to add up your capital gains, dividing them by long-term gains and short-term gains. If you sold some stocks earlier in the year for gains, you can offset, dollar for dollar, those gains.
This can be especially helpful, since there is a very real possibility that taxes on investments will be higher in 2013. Some investors are selling now while the top long-term capital gains rate is 15 percent, rather than 20 percent or higher. Some of those gains can be offset, though, if you sell some of your losing investments.
You can do more than just offset your capital gains with your investment losses. You can take the amount that you lost, beyond the amount of your gains, and deduct it from your other income, up to $3,000. So, if you have $10,000 in capital gains, and $14,000 in losses, you can completely offset your investment gains (no capital gains tax), and take $3,000 of it and use it to reduce your regular income, leaving $1,000 left over.
It's important to note this excess amount, since you can actually carry it forward to another year. In fact, you can carry your losses forward indefinitely. So that $1,000 can be used to offset those same taxes next year, or the year after that.
Wash Sale Rule
The ability to claim capital losses on your tax return to offset gains and income can tempt investors to sell at a loss, and then turn around buy the same investment again while the price is low. While it's not illegal to do such a thing, engaging in this type of activity means that you can't claim your capital losses on your taxes.
That type of activity is known as a wash sale. The IRS requires that you wait at least 30 days before you buy an investment that is "substantially identical" to the one you just sold. If you're going to claim investment losses on your taxes, you need to plan ahead and avoid a wash sale.
Choosing Which Investments to Sell
Make sure that you carefully consider which investments you plan to sell for tax purposes. The best choice is to sell investments that no longer meet your portfolio goals, or the criteria of a fundamentally sound value. Selling only because an investment's price has dropped is not normally a good idea.
Look at the fundamentals of the investment. If something has changed for the worse, it might be a good plan to sell. Investments that still show solid fundamentals, and may only be dropping because of market conditions, are more likely to recover in time. You might be better off buying more of such investments, while they are "on sale" than selling them to harvest tax losses and finding yourself unable to purchase the investments again until 30 days have passed.
As you plan your investment and tax strategies for the end of the year, don't forget to consider whether or not harvesting tax losses might make sense for you. Consult with a tax professional if you are unsure of how to proceed.
But if you do decide that selling for losses is desirable, you need to hurry up. In order to claim losses, your investments need to be sold, and cleared, by December 31.
Miranda is a freelance contributor to several investing and personal finance web sites. She also writes for her own blog, Planting Money Seeds.