Year-End Investment Decisions: Capital Gains and Losses

With 2017 quickly coming to a close, you definitely want to think about last-minute maneuvers that can help you save a significant amount of taxes. If you have an investment portfolio, now is definitely the time to think about whether you want to sell or hold your assets if doing so will have tax impacts. There are certain rules for netting capital gains and losses if you engage in a lot of investment activity. Here’s what you need to know about the intricacies of tax planning when it comes to capital gains and losses.

Long-Term vs. Short-Term Capital Gains and Losses, Ordinary and Capital Gains Rates

You may have heard the terms "realized gain" and "recognized gain" and there’s a major difference between the two. You realize a capital gain when the asset appreciates in value. However, you don’t need to worry about reporting it on your tax return until the gain is actually recognized. Capital gains are only recognized when you sell the asset.

In addition to paying attention to assets that appreciated in value and those that declined in value or became worthless, the length of time in which you held the assets is also important. Short-term capital gains and losses apply to assets held for less than one year, while long-term are for assets held longer than a year.

Long-term capital gains and losses are more favorable than short-term. When you have a net short-term capital gain, it is taxed at what’s known as the ordinary rate and without regard to the tax bracket that you are in. The ordinary rate refers to the graduated tax rates that apply to most of your income (such as wages and business profits.) Net long-term capital gains are taxed at a preferential rate which is 15% for most taxpayers or 20% for higher-income taxpayers in the 39.6% ordinary income bracket. If your income is in the bottom two tax brackets– 10% and 15%– you have a 0% long-term capital gains tax.

So, if you are in a higher income bracket for 2017 than you expect to be in 2018 due to career or lifestyle changes like starting a business, retiring, or taking a pay cut, then it’s wise to postpone your capital gains until 2018 if you can reasonably expect to be in one of the bottom two tax brackets.

The Limit on Capital Loss Deductions

If you have more capital losses than gains, you are limited to deducting $3,000 of your loss every year until you use it up. This is referred to as a carry-forward (or carry-over) and you can use it until your final tax return. There’s no time limit. For instance, if you have a $20,000 capital loss you can deduct $3,000 for 2017 then assuming you have no more capital gains, $3,000 for the next five years, then $2,000 in the final year.

However, if you have long-term capital gains in the future then this loss being carried over would be considered first when calculating your net capital gain for the year.

How Are Net Capital Gains Calculated?

First, you need to know your basis in that asset which is the purchase price plus whatever broker fees were paid. You deduct the basis from the sale price, along with any broker fees that were charged for the sale. In recent years, the IRS mandated that brokers started issuing tax statements differentiating covered transactions from non-covered. A covered transaction is one where your basis was reported to the IRS and non-covered means that it wasn’t. For non-covered transactions (such as stocks purchased prior to this mandate) you need to have adequate records of your basis.

However, the calculation for your net long-term and short-term capital gains isn’t as simple as aggregating the gains and losses for the year. The IRS utilizes the following formula: short-term gains are netted against short-term losses while long-term gains are netted against long-term losses. If both of these holding periods have the same results– both result in gains or both result in losses– then they are reported separately on Schedule D. Gains are  then taxed at the appropriate rate, ordinary for short-term and preferential for long-term, and your total capital loss can be deducted up to $3,000 against all your other ordinary income for the year with any excess amount to be carried over.

But if one holding period has a gain and the other one has a loss, then they need to be netted against each other after the above steps have been taken. For example, you have several covered transactions on your brokerage statement. You have $2,000 in short-term losses, $500 in short-term gains, no long-term losses, and $1,000 in long-term gains. The correct way to calculate your gain for the year is to net the short-term amounts together first so there’s a $1,500 short-term loss. With no long-term losses, this results in a $500 deductible capital loss after netting it against the $1,000 long-term gain.

Going back to the $3,000 per year limit and the $20,000 loss example, then this capital loss carry-forward would come first and the extra $500 would be accounted for. But if you have better luck in the market and have a huge capital gain? That carry-forward can help absorb it until it’s used up. So if you were only able to deduct $3,000 of your net capital loss in 2017 with a $17,000 carry-forward balance for 2018 and you suddenly have a $10,000 capital gain, then that loss absorbs it. Your deduction is still limited to $3,000 per year, but now you have a capital loss carry-forward of just $4,000 ($17,000 – $10,000 gain – $3,000 deduction) and no capital gains tax.

Ultimately though, there is no carry-forward for capital gains. Capital gains must be recognized in the year that the sale occurred and with the appropriate holding period. Only losses can be carried foward until they are absorbed.

In the event that you are facing a massive capital gain or loss, it’s definitely prudent to determine probable transactions in the future and what course of action is best to take. Large capital loss carry-forwards are more beneficial if you’re expecting equally large capital gains in the future. If you are expecting your income bracket to substantially change, this is also important for effectively planning how to make the most of a capital loss carry-forward as well as the timing of selling your assets. And if you’re in the lower two brackets and quickly need some cash for holiday spending, you can enjoy tax-free capital gains.