The Smart Way To Lower Your Tax Bill

Nick Lanyi's picture

Monday, December 28, 2015 - 7:30am

by Nick Lanyi

If you regularly follow the advice of StreetAuthority experts, you probably sold some winning investments in 2015. That's great news -- but of course, there's a downside: the capital gains tax you'll owe on those profits. So as we wind down to the final days of the year, it's worth considering an investment maneuver that can lower those taxes, or even eliminate them.

Smart investors use capital losses to offset gains in years when they've sold a lot of winners. By selling losing investments before December 31, you can lower your net gain and significantly reduce the tax bill you'll pay for 2015. But as with anything involving the IRS, you'll need to do it the right way: in this case, without running afoul of the "wash sale rule."

The IRS wash sale rule prohibits investors from claiming a capital loss on a sale if they buy back the same security within 30 calendar days. The rule applies to all of your accounts as well as your spouse's. Furthermore, you can't buy a "substantially identical" security as a replacement -- e.g., selling an S&P 500 index fund and buying another one.

And don't try to get clever with options, convertible securities, warrants or other derivatives that trade based on the underlying stock's value. The IRS won't allow that, either.

So, how can we harvest capital losses before year end without violating the wash sale rule or messing up our portfolio allocations?

The simplest scenario involves dumping investments that have lost money and that you are planning to sell anyway. It pays to be patient, and no one wants to "buy high and sell low." But some investments don't work out, and acknowledging mistakes and moving on often makes sense. Take a hard look at every stock, mutual fund or other security you own. If the reason you bought it no longer applies, or if other investments offer significantly more upside from this point forward, it may be worth selling to harvest the loss. Use the proceeds to invest in more-attractive stocks.

A more complicated choice involves losing investments for which the "buy" rationale still applies. At this point, your loss is on paper only -- and if the stock has fallen in value, it might well be more attractive now than when you bought it. Normally, I'd never recommend selling such a stock. However, if you feel confident the stock won't rebound in the next 30 days -- for example, if the market is waiting for a court or regulatory ruling, or if the stock is depressed because of external factors that are unlikely to change in the next few weeks, such as the price of oil -- you could sell it, wait 30 days, and buy it back.

Even better: sell the stock and use the proceeds to buy another one in the same industry that's equally or almost as attractive. You'll incur commission expenses, but harvest the capital loss to offset another gain and remain exposed to the same industry. If you choose, you could switch back to the original stock after 30 days without running afoul of the wash rule. For example, the share price of ExxonMobil (NYSE: XOM) is down almost 15% this year. You could sell your XOM shares and immediately invest the proceeds in Chevron (NYSE: CHV) to maintain your exposure to the integrated energy producer sector. After 30 days, you could switch back to ExxonMobil or simply hold on to Chevron. 

Here are some more examples of substitute stocks to consider for some prominent stocks that are tax-loss sale candidates. (Note that I'm not necessarily recommending either stock as a long-term holding.

Stock Substitute
Wall-Mart Stores (NYSE: WMT) Target (NYSE: TGT)
Macy's (NYSE: M) Kohl's (NYSE: KSS)
Freeport-McMoRan (NYSE: FCX) Newmont Mining (NYSE: NEM)
Yum! Brands (NYSE: YUM) McDonald's (NYSE: MCD)
Coca-Cola (NYSE: KO) PepsiCo (NYSE: PEP)

The Flip Side

One more strategic tip regarding tax loss sales: When the crowd is engaged in selling for reasons other than a stock's fundamental qualities, smart investors can find buying opportunities. This time of year, a lot of "losing" stocks get sold for tax reasons, pushing their prices down into bargain territory. The trick is to identify potential buy candidates first, then look for opportunities to buy -- especially in the second half of December -- when their valuations drop below a reasonable target. While you don't want to chase losers only because they appear undervalued, some high-quality stocks are worth owning if the price is right.

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Nick Lanyi does not personally hold positions in any securities mentioned in this article.
StreetAuthority LLC does not hold positions in any securities mentioned in this article.