Year-End Tax Planning: the race for tax-loss harvesting

It’s painful to admit that you’ve lost money on an investment. But even worse is leaving those losers in your portfolio, and ending up paying capital-gains taxes because the only investments you’ve sold this year were the winners.
Tax rules allow you to get a benefit from taking losses, and this year you may have gains you need to offset. While tax-loss harvesting is best done throughout the year, most investors think about it at year end. For 2011, you’ve got just a little time left to get it done.
Here’s how it works: The tax rules allow investors to offset capital gains with capital losses. Long-term gains on assets held more than one year (and taxed at 15 percent) are first matched against long-term losses, while short-term gains (taxed at your marginal rate) are paired against short-term losses. The long-term and short-term results are then matched against each other. If the result is a net loss, you can deduct up to $3,000 against ordinary income, while anything over that $3,000 amount can be rolled over to offset gains in future years.
After the financial crisis of 2008, many investors stockpiled losses so high they thought they’d never use them up. But three years later, those capital loss carryforwards are dwindling.
“A lot more people have gains this year,” says Brittney Saks, a personal financial services partner at PricewaterhouseCoopers in Chicago. “If people wanted to harvest losses in past years, they may have just been adding to the total. This year, those losses may get utilized.”
Of course, you should never take a loss solely for tax purposes. You’ll want to review your portfolio, and take those losses as you rebalance your asset allocation or rethink your strategy for the new year.
To figure out whether you’ll benefit from taking losses, you’ll first want to take a tally of your existing losses (including any tax-loss carryforward) and gains.
As you do that, you may run into the new rules on cost basis, which may give you an added reason to think about tax-loss harvesting. The cost basis of an investment is its price for tax purposes, and it’s used to determine whether you’ll report a gain or a loss to the Internal Revenue Service. But, as we’ve written before, there are many ways to calculate cost basis, and under new rules being phased in starting this year, if you didn’t choose how you wanted it calculated your broker will choose a default for you.
Because of those defaults, some investors may discover they have gains they weren’t expecting this year. Since you can’t go back and redo that calculation, the smart move is to offset the impact by taking capital losses elsewhere in your portfolio.
It’s worth remembering that losses can add to returns – and that the smartest institutional investors are also tax savvy. A study by Pasadena, California-based money-manager First Quadrant, for example, found that tax-loss harvesting may add as much as 7 percentage points to a portfolio’s return in the first year, and that even after 25 years it may add 0.3 percentage points.
The wild card here is tax rates. While the 15 percent capital-gains rate is set through 2012, it’s currently slated to expire after that. If that happens – and it’s anyone’s guess at this point – capital gains would become more costly in 2013, while capital losses would become more valuable.
If you’re thinking ahead and have large gains in your taxable portfolio, you might want to consider locking in the 15 percent rate on some of your gains, then buying back the same stock over the coming months in order to reset your cost basis for tax purposes before rates go up.
That’s not tax-loss harvesting, but it could be smart tax strategy.

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