Harvesting tax losses can reduce your tax bill.
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By Christine Benz | 08-07-08 | 06:00 AM | Email Article

A few weeks back, I cautioned against indiscriminate selling amid the recent market weakness. Holding tight to your holdings--or even adding more--when everything's going down is one of those strategies that feels terrible while you're doing it; after all, it's unlikely that you'll be able to pick the absolute bottom, so you're apt to see your stocks and funds drop further still. Nonetheless, buying more shares on market weakness is one of the best ways to improve your portfolio's results, because you're adding to your holdings at a lower cost than if you did so after the market rebounded. (Bill Bergman offered an interesting twist on this tack last week, pointing out that investors who purchased stock during recessionary periods outpaced those who invested money consistently throughout market cycles.)

Christine Benz is Morningstar's director of personal finance and author of 30-Minute Money Solutions: A Step-by-Step Guide to Managing Your Finances and the Morningstar Guide to Mutual Funds: 5-Star Strategies for Success. Follow Christine on Twitter: @christine_benz.

That said, the current downturn has been prolonged and painful enough that some selective selling could be in order. Given that the S&P 500 has lost 11% so far this year, and many stocks and funds have lost more than that, there's a good chance that some of the securities in your portfolio are cheaper than they were when you bought them. If you sell stocks and funds from your taxable accounts for a loss and those losses outweigh any capital gains you've realized during the year, you can use your losses to offset as much as $3,000 in ordinary income on your tax return for 2008. (Any losses you don't use this year can be carried forward to future tax returns.)

Round Up the Usual Suspects
So, where should you look for stocks and funds to sell? Obviously, not everything that's down should be on the chopping block, because some of your hardest-hit holdings could have the greatest rebound potential. One place to start, however, is to think about your honest-to-goodness mistakes. These are securities where you misjudged the fundamentals (or the fundamentals changed) and stocks and funds that were simply a poor fit for you to begin with. For example, perhaps you underestimated the risks inherent in a bank with a lot of mortgage-related exposure or you've decided that you didn't really need a health-care-specific exchange-traded fund because your portfolio already has plenty of health-care stocks. Morningstar's Stock, Fund, and ETF Analyst Reports do a good job of helping you gauge whether a security is fundamentally flawed or worth hanging on to. Click here for a 14-day free trial of Premium Membership at Morningstar.com.

Even if you don't have anything that you'd put in the category of a mistake, there's another category of investments for which you can be on the lookout when it comes to tax-loss selling: those for which there's a viable alternative in the same category or industry. For example, say you want to take a loss on a fund like  Vanguard Capital Value  but you don't want to give up on the value style of investing altogether; you could buy another value-oriented fund, such as  Longleaf Partners . (Longleaf currently lands in our blend category, but the managers use a true-blue value approach.) As long as you don't replace that stock or fund within 30 days with what the IRS calls a substantially identical security, you can book the loss but still retain exposure to that part of the market.

And even if you want to hang on to all of your stock and fund holdings, you can still improve your tax situation by selling the shares that you hold at a loss and hanging on to those in which you have a gain. This is particularly relevant if you purchase shares of stocks or funds at regular intervals. For example, say you bought 400 shares of a stock when it was trading at $13, another 400 at $10, and 400 more at $6, and the stock is now selling for $7. You could sell the first two, higher-priced lots, thereby realizing a loss, and hang on to the $6 batch, in which you have a gain. This method of selling is called specific share identification; if you go this route, remember that you must also use this same method for shares you sell in the future.

The Basics on Basis
Any discussion of tax-loss selling invariably highlights the importance of keeping close track of your cost basis--defined as the original purchase price plus any reinvested dividends or capital gains. If you haven't made subsequent purchases of a security and you're not reinvesting capital gains and dividends, arriving at your cost basis is easy--it's simply the price you paid for your first and only set of shares. For example, if you bought 1,200 shares of a non-dividend-paying stock for $10 apiece two years ago and they're now trading at $7, your cost basis is a straightforward $10. You're holding all of those shares at a loss, and they could be likely candidates for pruning.

If, on the other hand, you've bought shares at several intervals or you're reinvesting dividends and capital gains to buy more shares, calculating your cost basis isn't quite as cut and dried. You could use an average of your purchase prices to calculate your basis (there are two ways to do so, both outlined in this article, or you could use the specific-share identification method that I outlined above. Finally, you could calculate your cost basis by using the "first in first out" method that the IRS uses--essentially, you'd sell the shares that you purchased first. That method can work out just fine if you've purchased a security that has subsequently gone down in price, but you generally wouldn't want to go this route if you own a security that has appreciated steadily since you bought it.

Some investors use spreadsheets to document their purchase prices and reinvested dividends and capital gains; that, in turn, helps them keep close tabs on their cost basis and makes it easier to calculate your investment-related taxes. Your brokerage firm or mutual fund company may also provide this information on your statements or online; if they don't, you can call and ask for your purchase-price history along with any reinvested dividends or capital gains. For more details of why basis is important, how to calculate it, and how to keep track of it, check out this article.

 

 

 

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