Suppose you’ve carried forward a short-term capital loss from securities sales in prior years. Now you’re poised to sell stock at a sizable long-term capital gain.
Strategy: Think twice. From a tax perspective, it doesn’t make sense to use a short-term loss to offset a long-term gain, which is taxed at more favorable rates than a short-term gain.
Unless circumstances dictate otherwise, postpone the sale or realize a short-term gain instead.
Here’s the whole story: Under longstanding rules, you can use capital losses to offset capital gains plus up to $3,000 of ordinary income ($1,500 if you used married filing separate status). Any excess is then carried forward to the next year. So a capital loss carryover is like having an ace up your sleeve.
Conversely, the maximum federal tax rate on long-term capital gain is 15% for most investors. For 2013 and thereafter, the American Taxpayer Relief Act (ATRA) increased the maximum tax rate to 20% for single filers with taxable income above $400,000 and joint filers above $450,000. But even with the ATRA change, the tax rates for long-term gains still beat the tax rates on ordinary income for upper-income investors. The top ordinary income tax rate in 2013, which includes short-term gains from securities sales, is 39.6%—almost twice as high.
Therefore, if you use a short-term loss carryover to offset a long-term gain, you’re effectively wasting your best tax punch.
Example: You have a short-term loss of $10,000 that you carried over from 2012. Now you’re sitting on a long-term stock gain of $15,000 and a short-term stock gain of $12,000. You expect to be in the regular 35% tax bracket in 2013.
If you sell the stock producing the long-term gain, the carryover loss will offset $10,000 of your long-term gain. The remaining $5,000 gain is taxed at 15% for a tax of $750 (15% of $5,000). When you sell the short-term gain stock in 2014, the tax will be $4,200 (35% of $12,000), assuming no other changes. Total tax: $4,950 ($750 + $4,200).
Better approach: Sell the stock showing the $12,000 short-term gain. The carryover loss still offsets $10,000 of gain, but now you pay tax of only $700 (35% of $2,000) on the net short-term gain. When you sell the long-term gain stock in 2014, the tax will be only $2,250 (15% of $15,000), assuming no other changes. Total tax: $2,950 ($700 + $2,250).
In other words, this strategy saves you $2,000 ($4,950 – $2,950).
Tip: Don’t let the “tax tail wag the dog,” but factor taxes into investment decisions.