The year is rapidly coming to a close, so it's time to start thinking about the tax moves you'll need to make before the end of 2017.
If you're sitting on any losing investments in your stock portfolio, now could be a smart time to take a second look and decide if they're worth holding onto. If you decide to sell and move on, the loss could potentially get you a nice tax break.
We'll get into the rules in a minute, but the basic idea behind tax-loss harvesting (also known as tax-loss selling) is that if you sell an investment at a loss, you can potentially use that loss to lower your taxable income.
For example, let's say that you invested $5,000 in a stock a few years ago, and the investment is just not going your way. If the value has fallen to $3,000 and you sell, you'd have a $2,000 loss.
The IRS allows you to deduct capital losses on your tax return, effectively subsidizing your losing investments. So if you're sitting on a losing investment like I just described, and you've been on the fence when it comes to holding it or selling it, it's important to realize that if you decide to sell and redeploy that capital elsewhere, you could get a nice tax break.
Let's take a closer look at how this works and the rules you need to know.
Capital gains 101
To understand the rules of tax-loss harvesting, you first need to understand how the IRS classifies the sale of investments. There are two categories of investment gains (and losses): short-term and long-term.
If you have held a stock (or other capital asset) for one year or less, the sale is considered to be a short-term capital event. If the sale results in a profit, you may have to pay ordinary income tax on the gain.
On the other hand, if you hold the stock for at least a year and a day, the sale is a long-term capital event. Long-term capital gains are taxable at more favorable rates -- 0% for the lowest two tax brackets, 15% for the 25%-35% tax brackets, and 20% for the top tax bracket.
The rules for deducting capital losses
The first rule for tax-loss harvesting is that a capital loss must first be used to offset the same type (short- or long-term) of capital gain, if applicable. For example, if you have $3,000 in short-term capital gains and $1,000 in long-term capital gains, a $500 long-term capital loss must be used to reduce your long-term capital gains.
If the amount of your capital loss is greater than that type of capital gain, it can then be used to offset any other capital gains you have. In the previous example, if your long-term capital loss had been $1,500, $1,000 of that amount would offset your long-term gain, and the extra $500 could then be used to offset your short-term gains.
Finally, if your capital losses exceed your capital gains for the year, you are allowed to use up to $3,000 of the excess to reduce your other income. For example, if your adjusted gross income (AGI) for the year is $50,000 and you have a $2,000 capital loss and no gains, you can reduce your AGI to $48,000. If you have more than $3,000 in excess capital losses, you can carry the unused amount over to the following tax year.
The "wash sale" rule
One more rule you need to know is the "wash sale" rule. This basically says that if you plan to use a capital loss on your taxes, you cannot use the proceeds from that sale to buy a "substantially identical" investment within 30 days.
As an obvious example, this means that you can't sell your Macy's stock to claim a loss, and then repurchase Macy's shares just a few days later. As a less-obvious example, if you sell a Vanguard S&P 500 index fund at a loss, and buy a Schwab S&P 500 index fund within 30 days, it can also be considered a violation of the wash sale rule, making the loss unusable on your taxes.
The Foolish bottom line
If you've been sitting on a losing investment or two that you've thought about getting rid of, it could be smart to cut your losses, take the tax break, and move on to a more promising use of that capital. This is especially true if you have capital gains that will likely drive up your tax bill. Just be aware of the rules, and be sure to use your losses to offset the correct type of income.