How to Turn a Losing Investment into a Tax Break

tax-loss harvesting

There are a few things in life that absolutely no one looks forward to or cares for in the least; losing investments and taxes. On that note, I’m almost positive that I speak for just about everyone, ever, when it comes to that very broad and sweeping statement. Fortunately, we can find tax breaks in almost everything that we do throughout the year, and we can even turn our losing investments into something spectacular if we try hard enough. Chances are slim that all your investments are fat losers, but it does happen that some very likely are throughout the course of a year.

We are optimists over here, and we prefer to look at the silver lining. Forget that your investments lost money and turned out to be a waste of time and money. Focus on the fact that you cannot change the past, you can learn from your mistakes to improve your future investments, and you can turn those losers into tax winners. It’s called tax-loss harvesting, and the Internal Revenue Service finds it perfectly acceptable and absolutely legal.

Here’s how to take advantage of tax-loss harvesting and lower your tax liability for the year.

Sell Losing Stocks

There are tax shelters for the average Joe, you know. One way to go ahead and take advantage of tax-loss harvesting is to sell your losing stocks. You will sell your investments with the loss, then you will become someone who tax-loss harvests. When you sell losing stocks at a loss, you can use that amount to minimize what you would have paid in capital gains taxes. This is going to offset the amount that you claim as income, allowing you to pay fewer taxes by getting rid of losing stocks as quickly as possible.

Furthermore, you can still benefit from this particular activity by offsetting your investments that ended up losing without any capital gains taxes to pay. You can also lower your ordinary income by selling losing stocks and claiming them as a loss, as well.

The Fine Print

The IRS is nothing if not wordy – and a stickler for rules. You can tax-loss harvest all day long but if you don’t abide by the rules of the IRS, you will find yourself in more trouble than it’s worth. So, before you begin the process, go ahead and see what you can do to make sure your actions are perfectly legal and completely above what the IRS expects of taxpayers. Here’s what you need to know.

  • Cost Basis Calculation – you should keep very good records of what you paid for your investments, what they sold for and what they are worth when you decide to take advantage of tax-loss harvesting. You have to purchase your entire position in order to make a price work. If you did not purchase the entire position in an investment, the price varies significantly, and you have to keep that in mind for consideration when it comes to applying sales and losses to your investment portfolio as well as your income taxes.
  • Wash Sales Rule – if you make the decision to sell a losing stock at a loss and then decide to reinvest your money into a stock that is identical or very much like (the IRS uses the phrase “substantially similar”) to the one you sold, you will then lose the ability to claim that stock as a loss on your income tax return and your tax-loss harvesting career is immediately over before it even began.

What You Need to Know About Tax-Loss Harvesting

  1. Tax-Loss Harvesting applies only to investments in taxable accounts – you cannot offset gains that are not taxable, so don’t even think about trying to do this. So long as your investments are being held in taxable accounts, you’re good to go. However, if you cannot claim a loss on tax-sheltered accounts such as IRAs, 529s, 403(b)s or even 401(k) accounts.
  2. Low Tax Brackets Need Not Apply – you’re not saving any money in the tax-loss harvesting business if you are already in a low tax bracket. The lower your tax bracket, the lower your savings. This is because you are unable to invest as much as others in higher income tax brackets, which means your losses are a lot lower and your offsets are a lot lower. For many in low tax brackets (think 25% or lower) you’re not going to benefit from this tax benefit, so it’s not even worth your time to go into the process in most cases.
  3. You can only claim so much in losses – as far as your losses are concerned for 2015, you are only allowed to claim as much as $3,000. The good news is that those taxpayers with a particularly awful year in terms of loss can go ahead and apply their losses to other years, too, so that they can offset the cost of their losses as the time goes on. It’s a way for you to continue to make more money on your losses as future tax years come into play.
  4. Don’t sell just to save income taxes – there might not always be a reason to sell a losing stock. Sometimes you lose money because of something that will change in the future. That’s what the stock market is all about. The good news is that you don’t have to sell your loses for a loss if you don’t want to, and that doesn’t mean you’re incorrect. Sometimes stocks pick back up and turn around, and it’s better to hold onto those you know will do this in the future than it is to save a few hundred dollars on your income tax return by selling it at a substantial loss right now.
  5. You have to sell now – tax-loss harvesting for the 2015 year is limited; you have only until December 31 to go ahead and sell your losing stocks, so you need to get on that right now if it’s the financial decision that’s right for you and your investment portfolio. The IRS does not allow taxpayers to offset their income taxes for the current year if the stock is not sold during the current year.

One more financially lucrative piece of advice is to take your tax-loss harvesting to the next level. You lost on a stock, you’re going to save some money on your income taxes; now you have to use that money from the sale of your stock to do something else. Whatever you do, make it a lucrative decision. It makes no sense to use that money to vacation or splurge on something you’ve been wanting when you can reinvest it, use it to pay for your tax liability or even use it to pay down a debt so that you have more money to invest in the future. Make wise financial decisions and you can turn your loss into a benefit in a number of different ways. It’s not as difficult as it might seem to some.

Photo by Getty Images

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