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Tax-smart capital loss or gain moves to make now

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Roller coaster photo by Element5 Digital from Pexels

The markets have been gyrating a bit of late. We can blame new COVID-19 variants, fluctuating jobs numbers, worker shortages, inflation, and supply chain problems for the nerve-wracking ups and downs.

The chaos, economic and otherwise, is enough to prompt some investors to make moves, which also add to the market roller coaster.

Before reacting to one or a few days' ups and downs, take time this month to more carefully review your overall portfolio. Then decide whether it's a good time to sell or buy.

Either option could be a wise year-end tax move.

Tax loss harvesting: Let's look first at selling those assets that have gone down in value.

This is known as tax loss harvesting. The goal here is to sell assets that are no longer worth what you paid and use that loss to offset your capital gains.

This works when you had other holdings that you sold for profit, or are expecting year-end capital gains distributions and dividends. These will add to your taxable income. But by selling other assets for a loss, that negative amount can be subtracted from your gains.

If you have more losses than gains, you can use up to $3,000 of the bad investments to reduce your ordinary income. And if you're cashing out more than three grand in bad investments, you can carry that excess into future tax years, to offset gains then or, if still more, ordinary income again.

In this case, also consider getting a new investment adviser.

Netting long- and short-term losses: The key in this portfolio rejiggering is to sell losing holdings that are similar to your gains. Long-term losses count against long-term gains. These are assets you own for more than a year and which are taxed at the generally lower long-term capital gains rates.

Moves make in connection with investment property held for a year or less are short-term transactions. Short-term losses offset short-term gains. This is a particular help since short-term gains are taxed at typically higher ordinary income rates.

Helping avoid a surtax: Tax loss harvesting also can help if you might face the added net investment income tax (NIIT). This surtax took effect in 2013 and imposes an additional 3.8 percent tax one on a taxpayer's net investment income. This includes interest, dividends and capital gains, as well as rental income from real estate, royalty income from energy assets, and even intellectual property rights and passive business income.

The NIIT applies to the amount by which a taxpayer's modified adjusted gross income (MAGI) exceeds a certain threshold amount. The NIIT kick-in levels, which are not indexed for inflation, are $200,000 for single taxpayers and $250,000 for married jointly filing couples ($125,000 if spouses file separate returns).

Reducing your investment earnings by using corresponding losses could keep you from being hit by the NIIT.

Tax gain harvesting: Okay, now for some tax-related investment moves for all y'all wise investors. If all your assets have grown in value, good for you. But you still might want to consider selling some of them, too.

This process is known as tax gain harvesting. As the name suggests, you harvest capital gains when you sell stocks that have appreciated nicely, particularly the long-term holdings that are taxed at more favorable rates.

This is something to consider if you plan to hang onto the holdings for even longer. You sell the asset for a gain, then rebuy it to reset its cost basis.

Basis begins with the price you paid for the asset. Certain actions and transactions can increase an asset's basis. When you eventually sell that asset, its basis is used to calculate the profit you make. And it's the profit on which you pay tax.

To find your taxable profit, you subtract the asset's basis from its sales price. The larger your profit, the larger your potential tax bill. But by resetting the holding's basis at a higher level, you pay less later.

Here's a very simple, for-illustration-purposes-only example of the benefits of tax gain harvesting:

  • You bought 100 shares of XYX Corp two years ago at $50 a share, giving you a basis of $5,000. You sell the shares today for $75 apiece, or $7,500. That gives you a profit of $2,500 on which you owe no capital gains tax because you're in the 15 percent ordinary income tax bracket.
  • You use your $7,500 to rebuy 100 shares of XYX Corp at $75 a share. This resets your basis in the stock at $7,500.
  • In five years, you sell your 100 XYX shares when they have reached $125 apiece. That gives you $12,500.

Using your reset basis, you owe capital gains on $5,000 ($12,500 minus $7,500). You now are in the 25 percent tax bracket, meaning your capital gains tax rate is 15 percent, producing a tax bill on your profit of $750.

If, however, you had simply held the original $50 apiece XYX shares, your taxable profit on your final sale would have been $2,500 more or $7,500 ($12,500 minus $5,000). And your 15 percent capital gains tax bill would have been $1,125.

When to worry about wash sales: OK, I know some of my investing savvy readers are asking about wash sales.

Yes, the tax wash sale rule says you must wait at least 31 days to buy back the same investment. You also can't be pre-emptive and buy more of an asset that you're planning to sell a month in advance.

But this applies only to holdings you sell at a loss. The IRS doesn't want you making transactions just to take advantage of tax liability write-downs.

When you sell an asset for a profit, Uncle Sam has no problem with you buying more of it. Since you're making money on it, you'll owe tax on the gains … unless you have corresponding assets to sell at a loss.

So give your portfolio another once-over. It could be a good time to rebalance it, especially when you can do so by harvesting losses and/or gains to your tax advantage.

Roller coaster ride redux: Check out my tumblr blog Tumbling Taxes for a front-seat view on the Twister at Knoebels in Elysburg, Pennsylvania. It'll give you the same feeling you get when you watch your stocks take a dive!

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