Fine Tuning Capital Gains and Losses
Year-end has historically been a good time to plan tax savings by carefully structuring capital gains and losses. Conventional wisdom has always been to minimize gains by selling “losers” to offset gains from “winners,” and where possible, generate the maximum allowable $3,000 capital loss for the year.
Long-term capital losses offset long-term capital gains before they offset short-term capital gains. Similarly, short-term capital losses offset short-term capital gains before they offset long-term capital gains. (“Long-term” means that the stock or property has been held over one year.) Keep in mind that taxpayers may use up to $3,000 of total capital losses in excess of total capital gains as a deduction against ordinary income in computing adjusted gross income or AGI. Individuals are subject to federal income tax at a rate as high as 35% on short-term capital gains and ordinary income. But long-term capital gains are generally taxed at a maximum rate of 15%.
All of this means that having long-term capital losses offset long-term capital gains should be avoided where possible, since those losses will be more valuable if they are used to offset short-term capital gains or ordinary income. Avoiding this requires making sure that the long-term capital losses are not taken in the same year as the long-term capital gains. However, this is not just a tax issue; investment factors also need to be considered. It would not be wise to defer recognizing gain until the following year if there is too much risk that the property’s value will decline before it can be sold. Similarly, one wouldn't want to risk increasing a loss on property that is expected to continue declining in value by deferring its sale until the following year.
To the extent that taking long-term capital losses in a different year than long-term capital gains is consistent with good investment planning, a taxpayer should take steps to prevent those losses from offsetting those gains.
However, historical tax-planning logic may not apply when the tax rates are expected to be higher in the next year or two:
• Increasing Capital Gains Rates - The special long-term capital gains rates that have been in effect since 2003 sunset (end) at the end of 2012 and return to the pre-2003 levels of 10% and 20%! These federal rates are currently 0% for taxpayers in the 15% and lower tax brackets and 15% for those in higher tax brackets. Individuals with large long-term capital gains in their investment portfolios might consider selling those holdings in 2011 or 2012 to take their gains at the lower tax rates. The good news here is that the wash sale rules do not apply to assets sold at a gain. So if you like a stock, you are free to buy it back right away. If your state doesn’t have a lower tax rate on capital gains, then the additional state tax you’d pay from selling profitable capital assets will need to be weighed against the federal tax you’d potentially save when deciding whether to make tax sales before year-end.
• Raising Marginal Tax Rates – At least through 2012, we are assured of retaining the lower individual tax rates which are currently 10, 15, 25, 28, 33 and 35 percent. These rates apply to “ordinary” income. Without Congressional intervention, the rates are scheduled to return to their original levels of 15, 28, 31, 36 and 39.6 percent, beginning in 2013.
With record government deficits, taxes have to go up—campaign promises notwithstanding—and we can expect that to happen in the near future. The only questions are when, how much, and for whom? Conventional wisdom has always been to defer income, but with a potential for increased taxes it may be appropriate to consider accelerating income to take advantage of the current lower tax rates.
It may be in your best interest to review you current year tax strategy with an eye to the future to maximize your benefits from gains or losses associated with capital assets. Please call this office for assistance.