BGBC Partners, LLP Tax Update: Harvesting Capital Losses and the Wash Sale Rules
Farmers are always on the lookout for new methods and approaches to increase their harvest. In this segment of our Tax Update, we are going to introduce you to another type of harvesting that even you can employ – the harvesting of capital losses!
First, a brief summary of the capital gain and loss rules. A capital gain or loss is generated by the disposition of a “capital asset”. The tax code curiously defines a capital asset by what it is not. Section 1221 defines the term “capital asset” as property held by the taxpayer (whether or not connected with his trade or business), but does not include such assets as inventory, depreciable property, copyright, literary, musical, or artistic compositions, accounts or notes receivable acquired in the ordinary course of business, and a few other asset types. Stocks are not included in the list of excluded items and are therefore capital assets.
When the disposition of capital assets results in a loss, there are some intricate rules for offsetting them against income, but to simplify, capital losses can only offset capital gains, and for individuals, any excess of capital losses over gains can offset “ordinary income”, i.e., ordinary income means income generated from other than the disposition of capital assets, up to $3,000. The ability to offset capital losses with capital gains is the impetus behind the strategy of harvesting capital losses.
This strategy entails selling those stocks from your portfolio that have unrealized losses in order to offset any capital gains recognized throughout the year. Many investors still want to own the stock or investment which generated a capital loss and will repurchase it once the capital loss has been used. This repurchase may trigger a potentially draconian regime known as the “wash sale” rules, which seek to wipe out the capital loss benefit until a later period.
Under these rules if you sell stock or securities for a loss and buy substantially identical stock or securities back within the 30-day period before or after the sale date, the loss can't be claimed for tax purposes. This rule is designed to prevent taxpayers from using the tax benefit of a loss without parting with the underlying stock ownership in any significant way. Note that the rule applies to a 30-day period before or after the sale date to prevent “buying the stock back” before it's even sold.
When you participate in a dividend reinvestment plan, the wash sale rules may be inadvertently triggered when dividends are reinvested, if you have separately sold some of the same stock at a loss within the 60-day period discussed above.
Although the loss can't be claimed on a wash sale, the disallowed amount is added to the tax basis of the new stock, therefore allowing the loss to be used on a future sale (assuming the wash sale rule doesn’t also apply to that later period).
As an example, assume that Mr. Bell buys 500 shares of ABC Corp. for $10,000 and sells them on June 5 for $3,000. On June 30, Mr. Bell buys 500 shares of ABC again for $3,200. Since the stock was “bought back” within 30 days of sale, the wash sale rules apply. Mr. Bell can't claim a $7,000 loss. His basis in his “new” 500 shares is $10,200: the actual cost of $3,200 plus the $7,000 disallowed loss.
If only a portion of the stock sold is re-purchased, then only that portion of the loss is disallowed. So, in the above example, if Mr. Bell had only bought back 300 of the 500 shares (60%), he would be able to claim 40% of the loss on the sale ($2,800 under the facts involved). The remaining $4,200 of loss disallowed under the wash sale rules would be added to Mr. Bell’s cost of the 300 shares.
Note that while wash sale losses can't be claimed, gains can't be avoided. That is, if you sell stock for a gain and buy it right back, you must still report the full gain.
If you would like more information on this harvesting strategy or the wash sale rules, contact an experienced CPA. You never know, there may be a bountiful harvest waiting to be produced!
