How to Realize a Capital Loss for Tax Reasons
When an investment goes down in value and you sell it or exchange it for a different investment, you realize a "capital loss." There will be times where you may want to realize a capital loss on purpose for tax reasons to reduce your income tax bill. Capital losses can be used to offset capital gains, and potentially used to offset some ordinary income.
Why Realize a Capital Loss?
One reason you might consider intentionally realizing capital losses would be if you were incurring large capital gains in the same tax year.
Let's say you sold a piece of real estate, a business, or a mutual fund or stock with a large capital gain. You might be able to rearrange other investment holdings you have for the purpose of generating losses to offset your capital gain. This works best with mutual funds and exchange traded funds.
With mutual funds, by exchanging one fund for another, you can realize a capital loss for tax reasons without necessarily incurring a long-term investment loss.
Here’s an example of how this works:
- Assume you own a Vanguard S&P 500 Index fund. You bought it for $100,000 at the beginning of the year. The market went down, and it is now worth $70,000. You know in the long run the markets will recover, so you don’t want to sell it at a loss, but you would like to be able to use the loss for tax purposes.
- Instead of selling your fund and going to cash or moving into a different type of investment, you sell it and buy a fund that owns the same underlying stocks; the Fidelity Spartan S&P 500 Index fund, for example. Both funds own the same stuff: all of the stocks listed in the S&P 500 Index. Now, as the market recovers, your portfolio will recover.
- Since you switched to a different investment, that $30,000 loss will be considered a realized loss and you will report it on your tax return.
- The loss can be used to offset other capital gains you may have. $3,000 of the loss can be deducted against ordinary income. You can then carryover any remaining loss to the next tax year.
This strategy works well with mutual funds, or exchange-traded funds, as it is easy to find numerous funds that own the same underlying stocks. With this type of exchange, you can capture the tax loss while staying invested in the desired investment allocation.
Ordinary income tax rates are higher than capital gains tax rates. For someone in the 33% tax bracket, having an additional $3,000 of capital loss that could be deducted against ordinary income would save them an extra $390 a year (calculated by taking the difference between the 33% income tax rate and the 20% capital gains tax rate and multiplying by $3,000). For some tax payers it can save even more. When this strategy is used consistently it can add up to multiple thousands in tax savings over an investor's lifetime.
Capital Losses with Individual Stocks
With individual stocks, this strategy does not work in the same way. Although you can sell your existing stock, and realize the loss, you cannot easily replace it with a similar stock that would be expected to perform in the same way. You might come close by purchasing a stock in the same industry, but company-specific factors may lead one stock to perform quite differently than the other.
When selling investments to realize a capital loss for tax purposes, make sure you are buying investments with different ticker symbols. If you sell and buy the same security within 30 days, the wash sale rule may apply and your tax loss could be disallowed.
The wash sale rule does not apply if you sell and buy mutual funds with different ticker symbols, even if the two funds own the same underlying securities.