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Take your losses
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October 17, 2001: 9:23 a.m. ET
Here's how to make the best of losers without forfeiting tax or trading gains.
By Staff Writer Jeanne Sahadi
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NEW YORK (CNNmoney) - When you lose money on your taxable investments, you have two choices: Mope or make the most of it. The first response is certainly understandable, but the second is more lucrative.
One of the few advantages to a prolonged down market is the opportunity to harvest your capital losses. By strategically selling your losers, you can cut your tax bill now and possibly in years to come; and you can even position yourself to benefit from future gains in those securities you kiss goodbye.
Know the rules
But before issuing your sell order, keep two things in mind.
First, according to the IRS "wash-sale" rule, you may only claim a loss for a security if you don't buy the same investment within 30 days before or after the sale. That means there is a 61-day period, including weekends, holidays and the day of sale, during which you may not buy the security if you want to take the loss.
Second, there is a cap on how much you may declare in capital losses in any given year. The cap is equal to the amount you have in capital gains that year plus $3,000. Capital losses offset your capital gains dollar-for-dollar, so you will owe no taxes on your gains. The additional $3,000 is applied against your ordinary income. And, if you have more losses than you can legally claim in one year, the unused losses may be carried over to future tax years until they're used up.
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 USE LOSSES TO REDUCE YOUR INCOME TAXES
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Your federal tax bracket: 30.5%
Your capital gains: None
Your capital losses: $3,000
Your federal tax savings: $915 (3000 x 0.305)
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Given the difficult path Wall Street has traveled recently, you may not have capital gains for 2001. No matter. Use $3,000 of your losses to reduce your adjusted gross income (AGI).
By doing so, you increase your eligibility for various tax breaks that have AGI limits, and you save yourself money on income taxes. Just how much you save depends on your tax bracket, since loss-based tax savings are calculated like deductions, said Martin Nissenbaum, Ernst & Young's national director of personal-income-tax planning. If, for example, you're in the 30.5 percent federal tax bracket and can claim $3,000 in losses, you'll save $915 in federal taxes (3000 X 0.305). In addition, you may save even more on your state taxes if your state allows deductions for capital gains and losses.
Three strategies for harvesting losses
Armed with that information, you're now ready to decide how best to harvest losses without incurring Uncle Sam's wrath. There are three basic strategies you can use.
If you own a security that has lost its promise or no longer fits with your asset allocation, you can simply sell it and record the loss.
But if you like the security and want to keep it, you can create a loss in one of two ways. You can sell the security and then buy it back in 31 days. Or, if you don't want to forfeit your position because you anticipate near-term gains, you can temporarily double up on what you own and then sell the original bucket of shares 31 days later, said New York-based certified financial planner Doug Flynn.
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THREE SELL STRATEGIES TO HARVEST A LOSS
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Sell security
Sell security, buy it back in 31 days
"Double up" on your holding, then sell original bucket of shares in 31 days
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In other words, if you own 100 shares of a company, buy another 100 shares. In 31 days, sell the original 100. "It's a double-up strategy," Flynn said. If the share price goes up during that time, you're guaranteed to make money. If the share price falls or stays the same, you've preserved your position in the security and still can take a loss. Indeed, said New York-based CFP Richard Zito, if the share price has fallen significantly, you might even consider doubling up again after selling the original 100, since your replacement shares might now provide you with an opportunity to claim another loss.
But in order for the double-up strategy to be effective, you have to disciplined about selling your original bucket in 31 days. Otherwise you might lose the opportunity to take a loss and unwittingly alter your asset allocation. As with any smart investment, have a sell strategy. "Begin with the end in mind," Flynn said.
Avoid traps
If you've been purchasing a security through an automatic investment program or simply have bought it over time, you've been buying shares at different prices. To maximize your loss, be sure to sell those shares with the highest cost basis first, i.e., those for which you paid the highest price. Otherwise, the IRS will assume you sold the shares you purchased first.
In order to do this, Nissenbaum said, specify in writing to your broker or online trading company which shares you intend to sell by their date of purchase.
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THE MOST VALUABLE LOSS
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Since short-term capital gains are the most expensive -- they're taxed at your regular income tax rate versus the 20% charged for gains on investments held a year or more -- you'll save the most money if you can use your capital loss to offset a short-term capital gain.
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Also, if you're participating in an automatic investment program, you must redirect your purchases so that you don't unintentionally buy more of the same security within the wash-sale period.
If you do violate the wash-sale rule, your loss will be disallowed. But you still can make use of it. The loss may be used to boost the cost basis of your replacement shares. Since your cost basis is higher, that increases the likelihood you can sell your replacement shares at a loss or, if the share price rallies significantly, it will reduce the amount you have to declare in capital gains.
Strategize fund losses
If you have taxable losses in your mutual funds, there is a way to get around the wash-sale restrictions. Say you have a loss in a large-cap value fund. If you want to maintain your asset allocation, you can sell your losing shares and simultaneously buy shares in another large-cap value fund without violating the rule.
You'll be on far shakier ground, however, if you sell one index fund for another fund investing in the same index, although the argument may be made that the tax structures and sizes of the two index funds are sufficiently different, Nissenbaum said.
One other thing to keep in mind: When buying a replacement fund in the fourth quarter, check with the fund about its "record date." That's the day used to determine who is a "shareholder of record" and hence subject to the fund's capital gains distributions. Be sure to buy after that date, otherwise you will owe taxes on the fund's distributions for the year, even though you are a new investor. 
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