The Error-Proof Portfolio: Don't Neglect Tax-Loss Selling as 2012 Winds Down

With Bush-era tax rates set to expire at the end of 2012, barring Congressional action, one frequently discussed investment maneuver is capital gains harvesting. The idea, as discussed by financial-planning expert Michael Kitces in this video, is that you sell your winning holdings and owe taxes at today's low long-term capital gains rates--15% for most investors and 0% for those in the 10% and 15% tax brackets. You can even rebuy the same securities right away, but you will have reset your cost basis--that is, in the future, you'll only owe taxes on the amount of appreciation above your new purchase price.

But even while the sexy tax-gain harvesting idea has gained traction of late, that doesn't mean you should overlook that old faithful of year-end tax-planning maneuvers: tax-loss selling. If you sell stocks and funds from your taxable accounts for a loss, you can use those losses to offset your capital gains. And if 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 2012. (Any losses you don't use this year can be carried forward to future tax returns.)

Thus, people who are simultaneously long-term capital gain harvesting and tax-loss selling can reset their cost basis in their winning holdings while also neutralizing the tax effects of doing so.

Losers Hiding in Plain Sight
Don't think you have any losing holdings in your portfolio? Think again. Despite this year's robust rally--and the fact that stocks are well in the black, in aggregate, during the past three years--many investors still have losing holdings in their portfolios. In fact, fully 44% of stocks are in the red during the past one-year period, and 53% have an annualized loss during the trailing three-year period. True, many of these stocks are flaky micro-cap names that aren't in many people's portfolios, but the ranks of losing holdings during the past three years also includes widely held names such as  Cisco Systems (CSCO),  Citigroup (C), and  Suncor Energy (SU). Investors who bought stocks toward their peak in late 2007 are even more likely to be holding those names at a loss.

Because funds are diversified, fund investors might have to look harder to unearth losing holdings; just 3% of all mutual funds have posted losses during the one- and three-year periods. But the losers are out there, and they're not just oddball bear-market and alternative funds, either. Among the mutual funds with negative returns during the past three years, on an annualized basis, are widely held offerings like
 Artio International Equity (BJBIX),  Vanguard Precious Metals and Mining (VGPMX), and  CGM Focus .

Individuals who are using the specific-share-identification method of calculating their cost basis in their holdings--a method that enables them to cherry-pick which lots of their stocks and funds they'd like to sell--might be in an even better position to unearth and profit from their losers. For example, say you bought 400 shares of a stock when it was trading at $20, another 400 at $15, and 400 more at $6, and the stock is now selling for $17. If you were employing the specific-share-identification method, you could instruct your broker to sell the first highest-priced lot, thereby realizing a loss, and hang on to the $6 and $15 batches because you're holding them at a gain. (This article provides an overview of the various methods of calculating cost basis.)

Think Twice If...
Yet as attractive as tax-loss selling can be, the strategy isn't always a slam dunk. First, there's the evergreen advice that you shouldn't let tax factors dominate your investment decisions. If you believe in the fundamentals of a fund or company and don't want to have to wait 30 days after your sale to repurchase it--which you're required to do to avoid triggering the so-called wash-sale rule--you're better off standing pat. (Under the wash-sale rule, you can't claim a tax loss if you've repurchased the same or a "substantially identical" security within 30 days of selling it.) Check with your financial and/or tax advisor on whether realizing losses makes sense from both an investment and a tax perspective.

In addition, it's worth noting that capital gains rates are set to go up next year--from a top rate of 15% today to 20% in 2013--and if they do, your tax losses will be even more valuable at that time than they are today. If you're expecting to unload more securities in the future--when capital gains rates could be higher--you could be better off selling your losers then. Bear in mind, however, that what are losing securities in your portfolio today could shoot up in value between now and next year, which adds some uncertainty to the decision to wait. Obviously, there are a lot of moving parts here.

Also bear in mind that in the course of this article, I've focused on using long-term capital losses to offset long-term capital gains; things get a bit more complicated if you have both long- and short-term capital gains and losses, as outlined in this article. Finally, tax-loss selling is best used in taxable accounts; it doesn't apply to company retirement plans, and it rarely makes sense in IRAs, as I discussed here.

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