Stock Market Gains and Losses in Turbulent Times

The stock market can be up 500 points one day and down a similar amount the next. The swings in the market make investment moves challenging. Here are the tax rules you need to know about your securities activities at this time. The following information applies only to securities held in a taxable portfolio (not in tax-deferred accounts such as a 401(k) plan or IRA).

Sell or Hold?

The decision to sell or hold onto your investments primarily depends on your investment goals, view of the market in general, and the specific investment in particular. But tax consequences should be factored in to your decision to sell or hold.

If you hold onto securities, you have no gain or loss. Despite the swings in the value of your holdings from day to day, the so-called “paper” gains and losses don’t translate into tax results.

Gain or Loss?

If you sell securities, you will have a recognized gain or loss. Gain (or loss) is the difference between your “basis” (generally what you paid for the securities, including commissions) and the selling price (what you receive for your securities). The fact that a stock may have soared in value between the time you bought it and sold it has no impact on your tax gain or loss.

For example, in November 2003, you purchased 10 shares of XYZ stock for $1,000. By May 2007, the value of this holding has risen to a high of $5,000. You sell it in November 2008 for $800. You have a $200 loss. The fact that the value has fallen from $5,000 has no impact on your tax result.

Gains and losses are classified for tax purposes as short term or long term. Short-term gains and losses are the result of holding a security for 1 year or less. Long-term gains and losses are the result of holding a security for more than 1 year. Why the distinction? Because each category has different tax results. Long-term capital gains are subject to favorable tax rates-15% for taxpayers in tax brackets over 15%, and zero tax for those in the 10% or 15% tax bracket. (Higher capital gains rates apply to unrecaptured depreciation on realty and collectibles gains.)

Capital Losses

Capital losses can offset capital gains dollar for dollar. For instance, if you have $5,000 of capital gains for the year and $5,000 of capital losses, you won’t have any net gains on which to pay tax.

Capital losses in excess of capital gains for the year can offset ordinary income, such as salary and interest income, up to $3,000 ($1,500 for a married person filing a separate return).

Capital losses in excess of capital gains and the $3,000 deduction allowance can be carried forward and used in a following year. There is no time limit on capital loss carryforwards for individuals. Capital losses cannot be carried back.

When couples file jointly, it doesn’t matter which spouse had the loss, because it is reported on their Schedule D. However, if couples file separate returns, any capital loss carryover belongs solely to the spouse who was the owner of the asset that generated the loss. One spouse can’t use the capital losses of the other on his or her separate return.

When a person dies, capital losses die, too. Any such losses belong solely to the deceased individual; any capital losses incurred in the year of death, plus any capital loss carryovers, can be reported only on the deceased individual’s final income tax return. Capital losses that are not used up here are lost forever; they cannot be used by a surviving spouse on his or her return following the year of death.

Wash Sale Rule

The tax law doesn’t want you to be able to churn your holdings solely for tax advantage without really changing your economic position. To this end, there is a restriction in the tax law called the wash sale rule. This rule prevents you from recognizing a loss on the sale of a security if you acquire a substantially identical one within 30 days before or after the date of sale. For instance, if you sell 10 shares of Y Corporation at a loss on May 1, and 2 weeks later on May 15 you buy 10 shares of Y Corporation, you cannot deduct the loss on the May 1 sale.

The wash sale rule has no applicability to gains. You can sell for profit as often as you want (each gain must be reported). However, the wash sale rule applies to short sales. If you incur a loss when you close a short sale within 30 days before or after another similar short sale, the loss cannot be recognized.

The loss from a wash sale generally is not lost forever; it is preserved in the basis of the newly acquired security. Thus, the fact that you really suffered an economic loss when you made the sale is taken into account. You add the disallowed loss to the basis of the new security, so that when the newly acquired security is sold, the deferred loss will be recognized (or the gain will be minimized to the extent of the deferred loss).

Sales to Related Parties

Most securities are sold through the market. But if you sell a stock or bond (perhaps from a privately held corporation) directly to a person who is considered a related party, no loss deduction is allowed. A related party for purposes of the capital loss restriction includes most close relatives, such as a spouse, child, grandchild, great-grandchild, parent, grandparent, great-grandparent, or sibling. It doesn’t include other relatives, no matter how close you feel to them, such as in-laws, aunts and uncles, or nieces and nephews.

The capital loss restriction cannot be avoided by selling to a person not in the related-party list if that person is acting as a nominee of a related person. For instance, if you sell shares at a loss to a brother-in-law who is acting as the nominee of your sister, you can’t recognize your loss.

The rule that restricts your ability to report a loss on a sale to a related party isn’t limited to sales to your relatives. It also applies to sales to a related corporation (one in which you own more than 50% of the value of the stock) and certain other controlled entities, such as trusts and estates.

The disallowed loss can be salvaged if the related party then sells the security at a profit. The portion of the gain that reflects your loss is not taxed to the related party. Of course, you don’t benefit from the disallowed loss; you can’t deduct the loss when the related party sells the asset at a gain.