Lock in your 2007 gains while keeping taxes low.
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By Sue Stevens, CFA, CFP, CPA | 12-13-07 | 06:00 AM | Email Article

This is a magical time of year. There are holiday gatherings to anticipate and enjoy. Winter is on its way, but the first few snowfalls still seem novel. And you still have time to do some of the things you vowed to do before the year ends.

Sue Stevens, CPA, CFP, MBA, and CFA Charterholder, runs her own financial planning firm, Stevens Portfolio Design, and manages over $100 million in assets.

One of the most important financial tasks you can tackle is to dig into your portfolio's gains and losses and take action. Once you know where you stand, you can do some "tax-loss harvesting" or gifting before year-end, which can help reduce the taxes you pay on your next return.

Assess Your Gains and Losses
Before Dec. 31 you should take a careful look at your portfolio. Check your 2006 income-tax return to see if you have any tax-loss carryforwards (on Schedule D).

You may ask, "What the heck is a loss carryforward?" If you've lost money on your investments in the past, you may still have some of those losses hanging around on your tax return. 

These losses are the silver lining in some of your faulty investment choices in the past. You can use them now to help offset capital gains on investments that have soared in value.

Your next step is to see where you stand with realized gains and losses in 2007. A "realized" gain or loss applies to those investments you've sold in 2007 that either triggered a capital gain or loss. If you've already triggered capital gains, you may be able to offset the tax hit by using your capital loss carryforwards. To better understand how to use these gains and losses, let's review the "netting" rules.

Netting Capital Gains and Losses
When you sell an investment for less than you paid for it, you realize a capital loss. You can use capital losses to offset--or net out--capital gains in your portfolio.

Capital losses are deductible dollar for dollar against capital gains. In addition, individuals may deduct up to $3,000 in capital losses each year against their taxable income.

You'll need to know if your gains and losses are short-term or long-term. If you held an investment a year or less, it will be a short-term gain or loss. If you held an investment longer than a year, it will be a long-term gain or loss.

In general, short-term capital gains are taxed at your ordinary income-tax rate, which can range from 10% to 35%. Long-term capital gains, meanwhile, are taxed at lower, preferential tax rates from 5% to 15%. (Higher capital gains rates apply to collectible and unrecaptured 1250 gains--see IRS Publication 550.)

In general the netting calculation is a two-step process:

First, offset long-term capital losses against long-term capital gains. That's one account. Then, offset short-term capital losses against short-term capital gains. That's another account.

If both accounts are either positive or negative after you've offset gains and losses, stop here. If one account is negative and the other positive, add the two together.

If both the short-term and long-term accounts have net gains, then they retain their short-term and long-term characteristics and will be taxed accordingly.

If both the short-term and long-term accounts have net losses, then you can deduct up to $3,000 of those losses from your income. Amounts in excess of the $3,000 may be carried forward indefinitely to use in future tax years. You'll see that carryforward on Schedule D of your federal 1040 return.

If you have one account that's positive and one that's negative, just add the two together--netting them against each other. If you have enough capital losses, you can wipe out some or all of your capital gains for the year. As above, any unused losses can be carried forward indefinitely.

 Example 1: Both Accounts Have Net Losses 
Short Term
( $ )
Long Term
( $ )
Capital Gains3,0002,000
Capital Losses (4,000)(5,000)
Net Capital Income  (4,000)
$3,000 of the $4,000 loss may be used to offset ordinary income in 2007. The remaining $1,000 loss may be carried forward to 2008's tax return.

 Example 2: One Account Has Net Gains, One Has Net Losses 
Short Term
( $ )
Long Term
( $ )
Capital Gains3,0007,000
Capital Losses (4,000)(5,000)
Net Capital Income 1,000
The $1,000 net capital income is considered a long-term gain on your 2007 tax return.

IRS Schedule D and its instructions walk you through this process, but for more information read Publication 550.

Tax-Loss Harvesting
Now that you understand the basics, you're ready to do some harvesting. You'll need three pieces of information: 1) Do you have any loss carryforwards? 2) What are your realized gains/losses to date? 3) What are your "unrealized" gains/losses (unrealized gains and losses pertain to investments you are still holding)?

Review your portfolio to see if there's anything you have considered selling that would help from a "tax harvesting" perspective. For example, you may hold a stock or mutual fund with an unrealized loss (a loss on paper only). If you have some realized gains for the year to date, you may choose to sell a security with losses to help offset a gain you took earlier in the year.

Or, if you have tax-loss carryforwards from prior years' tax returns, you may want to see what unrealized gains you have on securities you might want to sell. For example, you may have appreciated stock that you'd like to pare back for diversification reasons. Those loss carryforwards can help you do that in a tax-efficient way.

Worry less about triggering losses than gains. You can take up to $3,000 of capital losses against ordinary income each year. Unused losses can be carried forward indefinitely. On the other hand, you'll have to pay taxes on gains. Fortunately, capital gains are taxed at 15% in most cases.

Watch Out for Year-End Mutual Fund Distributions
If you're thinking of doing a little harvesting in your portfolio, keep in mind that mutual funds frequently make year-end capital gains distributions that can throw a monkey wrench in your strategy. (Funds have begun making distributions in the past few weeks.)

If you're planning to sell a mutual fund with gains to use up some of your loss carryforwards, do it before the fund makes its year-end distributions. That lets you control your gains and losses. To find out when to expect year-end distributions, contact your mutual fund company or check its Web site.

Think carefully before you buy a fund at this time of year, too. You may want to wait until after it makes its year-end distribution.

Gift Appreciated Assets
If you've done a good job of investing over the years, you may find that you just don't have enough losses to offset your capital gains (a good problem to have!). Consider giving those appreciated assets to someone else (of course, you need to make sure you have enough for your own needs before you do this).

By gifting highly appreciated assets to someone in a lower tax bracket (typically kids or grandkids), you effectively remove that asset from your estate and the person receiving the gift (the "donee") pays less in taxes when the asset is sold.

When you gift an asset, the basis carries over to the donee. So if you have stock that has appreciated significantly over the years, you can give it to someone in the 10% to 15% tax bracket, and he or she will only pay 5% capital gains tax on the appreciation. If you're in a higher tax bracket, you would have had to pay 15% capital gains tax.

In 2007 you can give up to $12,000 to as many people as you'd like with no gift tax owed. Gifts to qualified charities can be even larger and you'll get a tax deduction for your gift. For more on charitable giving, see IRS Publication 526.

A version of this article appeared Sept 21, 2006.

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Sue Stevens, CFA, CFP, CPA does not own shares in any of the securities mentioned above. Find out about Morningstar's editorial policies.
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