Investment Losses: Use Them to Reduce Taxes

We know that investments go up and down, and that different types of investments tend to go up and down at different times. We also know that the IRS provides us with a couple of avenues for using our investment losses to lower our tax bill. The trick is to know the rules and then manage our investments in a way that gives us maximum tax advantage.

Here are the avenues for using investment losses:

Right of Offset

Realized investment losses can be used to offset realized gains - dollar for dollar. Assuming you have a diversified investment portfolio, you probably have some winners and some losers. If you could offset gains with losses, you'd save considerable tax.

Example: You have $10,000 in paper profit in a handful of investments and more than $10,000 in paper losses on another handful of investments. Why not sell both (turn them from paper to real)? This way you're no worse off in the losers (they are simply worth today what they are worth today, and you can place the money back in the market after you've used them to shelter the gains on your winners), but your winners netted you more (i.e., you avoided paying tax on the gain).

Again, realized gains will be taxed unless you have losses that can be used to offset them. Typically, a portfolio will have a lot more winners than losers. So, the losers are at a premium, if you will. When your portfolio contains losers, such as during bear markets, try to "harvest your losses" and use them to shelter gains on winners. This doesn't mean you have to get out of the market. Just turn some unrealized gains and losses into realized gains and losses - for the purpose of lowering your tax bill - and put your money right back in the market (but beware of "Wash Sale" rules).

Net Loss Deductibility

Each year, the IRS lets you deduct from taxable income up to $3,000 in investment losses^*. So if each year you find $3,000 in losses and use them to shelter taxable income, you reduce your taxes each year by $1,050 (assuming you are in the 35% tax bracket). But if your net losses are more than $3,000, you can allocate the excess to future years -$3,000 per year. Time value of money reduces the value of future deductions, of course, so savvy management will pay dividends.

^{*Realized losses. Paper losses don't qualify. Talk to your financial advisor.}

This year has been abysmal for investments such as publicly traded stocks and bonds. Both are down. The silver lining is that you can use investment losses to reduce taxable income so long as you are willing to turn paper losses into real profits and work around IRS offset rules and annual net-loss deductibility limits.

Wash Sale Rule

If you sell a stock or bond and then buy it (or something very similar) back within 30 days, IRS may take away any tax deduction you attempt to take: the "wash sale" rule.

Note: Unused capital loss credits expire when the taxpayer dies. That is, the surviving spouse or estate will not be able to use unused capital loss credits of a deceased.