Market Correction Blues? Don't Write Off Tax Selling

In tough markets, investors are often advised to find a silver lining by engaging in tax-loss selling. By selling securities that are trading for less than they paid for them, they can net tax losses that they can use to offset capital gains and, if they still have excess losses, up to $3,000 in ordinary income.

But for some investors, that advice rings a little hollow. On many household balance sheets, taxable accounts--typically the only account type where it makes sense to engage in tax-loss selling--are but a small piece of the overall pie. Investors' IRAs and 401(k)s are where the real money is, but tax-loss selling from those accounts rarely makes sense, as discussed here.

Moreover, many investors use their taxable assets to fund near- and intermediate-term goals--to purchase cars and stash money for tuition, for example. That makes it more likely that they're using bonds and cash to fund those goals, not stocks, and so they're less likely to own good tax-loss candidates there, period. High-quality bonds don't exhibit the same price volatility that equities do, so pruning them for tax losses won't often make sense.

Finally, even investors who do hold sizable taxable accounts with sizable equity positions may have trouble locating good tax-loss candidates, especially if they're primarily fund investors. Only slightly more than 5% of mutual funds have had negative returns during the past five years, and many of those losing funds hail from niche categories that appear in few investors' portfolios, such as bear-market and Latin America stock funds.

Yet, investors shouldn't necessarily write off the whole endeavor. Tax-loss selling may still make sense in certain instances.

Tax-Loss Selling for Fund Investors As noted above, many fund investors might not be able to identify worthy tax-loss candidates, especially if they don't trade frequently and they're averaging their cost basis rather than using the specific-share-identification method. (The differences in cost-basis methods are outlined here.) They probably have gains, rather than losses, in their holdings over their holding periods. Emerging-markets funds may be the notable exception, as they're the rare fund type that's both widely held and has been in negative territory during the past three- and five-year periods (and even further in the red during the past year).

Fund investors using the specific-share-identification method for cost basis may be able to find an even greater array of worthy tax-loss candidates, however, as more recent additions may well be trading below their cost basis. For example, the

Various foreign-stock fund categories, especially those focused on emerging markets, have fallen even further than the broad U.S. market and, therefore, could be even more lucrative tax-loss sale candidates for investors using the specific-share-identification method. Ditto for investors who own sector-specific funds focused on the energy, precious-metals, or commodities spaces.

Tax-Loss Selling for Stock Investors Stock investors using the specific-share-identification method also have quite a bit of latitude to unearth worthy tax-loss candidates, especially among their most recent additions. More than half of the U.S. stocks in Morningstar's database have declined in value during the past one- and three-year periods. Of course, many of these are flaky, fly-by-night companies that appear in few investors' portfolios. But 80 individual U.S. stocks with market values of more than $25 billion are selling below their price from three years ago, and 67 are in negative territory during the five-year period. Many of these are concentrated in the energy sector, but the mining, technology, and banking sectors are also well represented.

Beware the Wash-Sale Rule The hitch with tax-loss selling is that you might expect some of these funds and stocks to recover. That means that even if selling makes sense from a tax standpoint, it may not add up from a big-picture returns standpoint.

Unfortunately, it's not as simple as selling a security, booking a tax loss, and then rebuying the same security immediately thereafter. Purchasing the same or what the IRS calls "a substantially identical" security within 30 days of selling it would trigger what's called the wash-sale rule and would disqualify you from claiming the tax loss.

Fund investors have quite a bit of latitude to circumvent the wash-sale rule, however, in that they can sell a laggard and swap into another offering that gives them similar exposure. While selling an emerging-markets index fund and buying an emerging-markets ETF would probably run afoul of the wash-sale rule, selling an emerging-markets index fund and buying an actively managed one (or vice versa) should pass muster. Tax-loss selling may also provide an opportunity to swap out of an investment type that, in hindsight, wasn't a great fit for you. For example, you may decide that you didn't need a region-specific Latin America stock fund and that a broad emerging-markets fund is a better idea.

For stock investors who like an individual stock that's selling below their purchase price,

can help them avoid the wash-sale rule while maintaining a position in the same unloved industry. For example, both