





Most of us are aware that you have to net out your capital gains and losses when figuring your taxes for the year. But how does all this netting work? Should I be hanging around the local dock to learn how to net my capital gains and losses? Let's try to unravel some of this mystery.
First, there are a couple of levels of netting. Longterm items are netted separately from shortterm items. Then, the long and short are netted together to produce the final result. It's easiest to just look at an example.
Example: Long John Silver sold two stocks so far this year. Both were held for more than a year, so they are longterm items. Long John had a gain of $1,000 on his investment in Fishing.com  an Internet startup selling trout and salmon online to unlucky fisherman  but a $600 loss on FishRUs  a retailer of fishshaped toys for kids. Subtract the loss from the gain and we find that he has a net $400 longterm gain.
Now, let's say that he sells two more stocks before yearend. His investment in Mackerel Industries has turned out to be a real stinker. So he unloads it for a $300 shortterm loss. And Minnow, Inc. turned a small shortterm gain of $50. Net these two items together, and Long John has a $250 shortterm loss.
Finally, we net the shortterm items with the longterm items and find that Long John has a net $150 longterm gain.
If you roll this around in the gray matter for a while, you'll find that everything will boil down to one of four situations:
 longterm gain with shortterm gain
 longterm loss with shortterm gain
 longterm gain with shortterm loss
 longterm loss with shortterm loss
LongTerm Gain With ShortTerm Gain
Ahhh  investment nirvana! Everything nets out to a winner. Your taxes here are pretty simple. (Don't worry, though, they'll get more challenging as we go along.) The longterm gain gets the preferential rate of 10% or 20%, depending on your tax bracket. The shortterm gain is taxed with your other income at your marginal rate.LongTerm Loss With ShortTerm Gain
We have to look at two situations here. If the gain is bigger than the loss, you have a net shortterm gain  taxed at your marginal rate. If the loss is bigger, you have a net longterm loss. Up to $3,000 can be used to offset other kinds of income. Any unused amount will carry forward to the following year as a longterm loss.LongTerm Gain With ShortTerm Loss
Again we have to consider two scenarios. If the gain is bigger than the loss, you have a net longterm gain and get to take advantage of the favorable rates for the net gain. If the loss is larger, it is a net shortterm loss and, just like the previous situation, you use up to $3,000 of the loss against other types of income, with any balance carrying forward to the next year as a shortterm loss.LongTerm Loss With ShortTerm Loss
Have you ever considered index funds? This one looks simple, but there is a twist. By now, you know that a maximum of $3,000 in losses will offset ordinary income. So, if the total of the two losses is less than $3,000, you're done. But what if the total loss is more than $3,000 and some must be carried over to next year? Is the carryover shortterm or longterm? Well, it can be just longterm or a combination of long and shortterm. But it will never be just shortterm. Why? Because you must use the shortterm losses first. If your shortterm losses are more than $3,000, you use the first $3000 to offset ordinary income, then carry the remaining shortterm loss along with all of the longterm loss over to next year. If the shortterm loss is less than $3,000, you can just total the two losses together, take the $3,000 off, and the balance is a longterm loss carryover to the following year.So, the process for determining the longterm or shortterm character of your capital gains and losses can be summarized in three steps:
 Net your longterm items together
 Net your shortterm items together
 Determine which of the above four situations applies to you and follow the instructions there.
Fool on!
Please note that Roy and Dave cannot answer individual questions via email. If you have tax questions, please ask them on the taxes message board. Thanks!