Profit From Your Losses

Each year in November and December, the stock market is affected by a phenomenon known as "tax-loss selling." Investors sell stocks whose price has fallen substantially in order to claim a loss on their income taxes for that year. We often see institutional tax-loss selling in November (fund managers don't want "losers" on their books at the end of the year) and individual investors generally sell in December, although tax losses can be claimed for sales made any time of the year. Let's look at a few different scenarios.

Scenario 1
Say you bought 100 shares of Symantec (NASDAQ:SYMC) at $34 and today they are trading at $18. If you sold your Symantec shares, you would incur a loss of $1,600. Assuming that you had no other gains or losses, you could apply this capital loss to your 2005 income at your marginal tax rate. At a 15% tax rate, Uncle Sam will give you a $240 tax credit; at a 25% tax rate, you'll see an even better credit of $400. You can claim up to $3,000 in capital losses each year and carry forward losses in excess of $3,000 to future years.

Scenario 2
Despite your losses, you believe that Symantec shares are now undervalued and you want to hold your shares. You can still take the tax loss by selling your shares now and repurchasing them 31 days after your sale. The IRS will not let you claim a tax loss if you repurchase within 30 days -- this is known as the "wash sale" rule. Under the same rule, you cannot purchase shares within the 30 days prior to your sale and claim a tax loss. So if you want to take advantage of this scenario, you must purchase at least 31 days before or after your sale.

Scenario 3
Say that last September you bought 100 shares of Motley Fool Inside Value pick First American (NYSE:FAF) at $29, and decided to sell them today at $47 for a 62% gain. Since you have held these shares for more than a year, Uncle Sam will tax you at the lower capital gains rate. The capital gains tax rates are 5% for those in the 15% income tax bracket and 15% if your tax bracket is 25% or higher. At the 15% rate, your tax liability is $270 of your $1,800 gain. Had you also bought and sold 100 shares in Symantec as outlined in Scenario 1, you could net out your $1,600 loss against your $1,800 First American gain. The result would be a $200 long-term capital gain.

Short-term and long-term gains and losses
There is a distinct tax advantage to holding your winners for at least a year and a day so that you can take advantage of the lower capital gains rates. If you sell within a year, your gains will be taxed at your marginal tax rate. The difference is quite substantial.

When netting out losses and gains, Uncle Sam throws in a few more wrinkles. First, we must net all long-term items together and then net all the short-term items. We can then net the short- and long-term items together to calculate the final loss or gain. Let's take a look at a mix of short- and long-term examples:

• August 2004: Bought 60 shares of ConocoPhillips (NYSE:COP) at $39* per share (cost = $2,340).
• June 2004: Bought 100 shares of Gap (NYSE:GPS) at $25 per share (cost = $2,500).
• January 2005: Bought 140 shares of Motorola (NYSE:MOT) at $17 per share (cost = $2,380).
• June 2005: Bought 130 shares of AnnalyMortgage (NYSE:NLY) at $19 per share (cost = $2,470).
  *Split-adjusted

In order to take advantage of tax losses and lock in some gains, you decide to sell all four positions in late December this year. This results in the following gains and losses:

• ConocoPhillips: Sold at $64 for a $1,050 long-term gain.
• Gap: Sold at $17 for an $800 long-term loss.
• Motorola: Sold at $23 for an $840 short-term gain.
• Annaly Mortgage: Sold at $12 for a $910 short-term loss.

First, we take the net of the long-term items and come up with a long-term gain of $250 ($1,050 - $800). Then we net the short-term items for a short-term loss of $70 ($910 - $840). Finally, we net the $70 short-term loss and the $250 long-term gain to arrive at a $180 long-term gain. Note that the result is long-term because the long-term gains were larger than the short-term losses.

The January effect
Another way to take advantage of tax-loss selling is to hunt for high-quality companies that have suffered a substantial decline in their stock price in the last year. These are likely to be dumped by investors who want to take advantage of tax losses and possibly repurchase the shares after 31 days. For example, Dell (NASDAQ:DELL) is down from $42 last January to $30 today. Tax-loss selling during November and December may give new shareholders an opportunity to buy shares from those selling for tax losses. The 31-day period necessary to avoid a wash sale may be one of the reasons for the "January effect." January has generally been a positive month for the stock market, and many theorize that this is due to investors repurchasing shares they sold for tax losses. The effect is more noticeable in small- and mid-cap stocks.

Foolish final word
I have kept my examples simple for the purposes of this article. If you are contemplating selling to capture a tax loss, I recommend that you consult a financial advisor or tax professional before you do so. Each situation is highly personal and other tax items, including other capital gains, will affect the decision. If you have potential tax losses, it is worth the consultation fee because this is one of the few areas in which Uncle Sam can help you improve your long-term, after-tax investment returns.

Philip Durell, advisor/analyst for the Fool's Inside Value newsletter service, owns shares in First American. To date,Philip's picksare outperforming the S&P 500. If you'd like to join Philip on the search for undervalued stock opportunities, you can sample his service for30 days for free. Gap and Dell are Motley Fool Stock Advisor picks; Annaly Mortgage is an Income Investor recommendation. The Motley Fool isinvestors writing for investors.