A useful year-end move to counteract capital gains.

Even though this has been a poor year for the market, you may realize short-term capital gains. What do you do about them? You could do what many savvy investors do - you could "cash in your losses" and practice tax loss harvesting.
Selling losers to offset winners. Tax loss harvesting means taking capital losses (you sell securities worth less than what you first paid for them) to offset the short-term capital gains you have amassed.

While this doesn't get rid of your losses, it can mean immediate tax savings. It can also help you diversify your portfolio. It may even help you to position yourself for improved long-term after-tax returns.

The tax-saving potential. Sure, you can use this technique to put your net gains at $0, but that's just a start. Up to $3,000 of capital losses in excess of capital gains can be deducted from ordinary income, and any remaining capital losses above that can be carried forward to offset capital gains in upcoming years.1

So by taking a bunch of losses this year and carrying over the excess losses into 2009, you can potentially shelter some (or maybe even all) of your long-term and short-term capital gains next year. This gives you a chance to shelter winners you've held (even for less than a year) from being taxed at up to 35%.1

The strategy in action. It is really quite simple. Step A is to pick out the losers in your portfolio. Step B is deciding which losers to sell and telling your financial advisor what you want to do.

However, both investor and advisor have to watch out for the IRS "wash sale" rule. You can't claim a loss on a security if you buy the same or "substantially identical" security within 30 days before or after the sale.2 In other words, you can't just sell a stock or mutual fund to rack up a capital loss and then quickly replace it.

But … you might be able to avoid the wash sale rule by using an ETF to make a "tax swap": an ETF for a stock or mutual fund, or even an ETF for another ETF if the ETFs are linked to different indexes.3 Although these "tax swaps" are widely done, this is still sort of a gray area, so consult a qualified tax advisor first.

Here's a heads-up: a new IRS ruling (Revenue Ruling 2008-5) says you can no longer use an IRA to acquire "substantially identical" securities within the 61-day wash sale window - and you can't boost your tax basis in said IRA by the amount of the disallowed loss.4

The (minor) drawbacks. You may not wish to alter a carefully chosen portfolio to the degree that you must for tax loss harvesting, especially if it has been built for the long term. Also, you could end up missing a rally in which a stock, ETF or mutual fund you've sold could take off. Transaction costs do add up, so a fee-based account makes sense when tax loss harvesting.
Will long-term capital gains be taxed more in the future? They could. President-elect Barack Obama has talked about possibly raising the long-term capital gains tax rate for taxpayers earning over $250,000 per year from 15% to 20%.5 Is that you? If so, you might think of triggering excess capital losses in 2008 and using the losses to shelter future long-term capital gains that could be taxed at a higher rate.

Not just a year-end tactic … also a year-round strategy. Some investors harvest losses throughout the year, not just in December. You may want to ask your financial advisor how you can harvest losses this holiday season and beyond.

Citations.
1 smartmoney.com/personal-finance/taxes/a-down-stock-market-offers-tasty-tax-breaks/  [10/29/08]
2 irs.gov/publications/p550/ch04.html#d0e12561 [TY 2007]
3 filife.com/stories/market-meltdown-opens-door-to-tax-swaps-rebalancing [10/26/08]
4 smartmoney.com/personal-finance/taxes/A-Sneaky-New-Twist-on-the-Wash-Sale-Rules-23611/?page=all [8/6/08]
5 blogs.abcnews.com/politicalradar/2008/08/obama-clarifies.html [8/14/08]