Saving on Taxes This Year (from WSJ) and Election Economics

Use the IRS to Ease the Bear's Big Bite

By Tom Herman, The Wall Street Journal
Last update: 9:38 a.m. EDT Aug. 19, 2008

Even for many of the nation's most sophisticated investors, this has been an unusually painful year. But there are valuable tax-saving strategies to consider that may help ease the sting.
As painful as it is to lose money, investment losses can reduce taxes significantly. For example, many investors can benefit by using a technique known as "tax-loss harvesting," or selling losers in order to offset gains on their winners -- and, in some cases, regular income, too.
"In these volatile markets, we're constantly harvesting losses" for clients, says Nadine Gordon Lee, president of Prosper Advisors, a wealth-management firm based in Armonk, N.Y.
To be sure, never make any investment move exclusively for tax reasons, warns Bob Gordon, president of Twenty-First Securities and co-author of the book "Wall Street Secrets for Tax-Efficient Investing." "Don't let the tail wag the dog," he says.
But don't make important investment moves without at least considering the tax implications.
Here's a primer on the capital-gains rules, including a peek at what may lie ahead next year.

The Basics

Investors can offset capital losses against gains on a dollar-for-dollar basis, with no upper limit. Suppose you sold a stock early this year that you purchased years ago, and your profit was $5,000. Now, you sell another stock for $5,000 less than you originally paid for it. Put the two together, and your net gain is zero. That means no capital-gains tax on your earlier gain.
Now suppose you have capital losses but little or no gains. If your losses are bigger than your gains, or if you don't have any gains, you typically can deduct as much as $3,000 of your net losses from your other income, such as wages, dividends and interest. (The limit is $1,500 if you're married and filing separately from your spouse.) Additional loss amounts are carried over into future years. Thus, if you were thinking of a selling a loser anyway, this could be a good time to pull the trigger.
These rules once prompted a memorable query from a reader. He had amassed $2.1 million of stock-market losses and was searching for a woman with large capital gains who would be interested in marriage. "My CPA tells me it is not necessary to live together, and a divorce can be had after the tax loss is used up," he wrote.
Some investors assume there is only one capital-gains tax rate: 15%. Wrong.
The rate can depend on several factors. If you sell a stock or mutual fund you've owned for a year or less, that's considered a short-term gain, and it's typically subject to tax at higher ordinary income-tax rates.
Under a provision that became effective Jan. 1, investors in the two lowest ordinary income-tax brackets may qualify for a long-term capital-gains rate of zero. (Tax-preparation software can help you figure this out.) Separately, the top rate on long-term gains from art and collectibles is 28%.
For more on this and related issues, see IRS Publications 550 and 564 ( irs.gov).
If you're planning to make a gift of stock to your favorite charity, pick your holdings with long-term gains (investments you've held for more than one year), says Tim Hanford, a tax consultant in Bethesda, Md. If you itemize your deductions, you typically can deduct the stock's fair market value -- and you won't owe capital-gains tax on the appreciation.
But don't donate a stock that's dropped in value, Ms. Lee says. Instead, consider selling it, use the loss to save taxes, and donate the proceeds to your favorite charity.

Wash Sales

A wash sale typically occurs if you sell a stock or some other security at a loss and then buy the same thing, or something "substantially identical," within 30 days of the sale. (That means 30 days before or after the sale, not just 30 days after.) Violate this rule, and you can't deduct your loss. Instead, you're supposed to add the disallowed loss to the cost of the new stock, and that becomes your basis in that stock.
To avoid trouble, don't buy the same security, or something substantially identical, within the specified period. Wait until later or pick something else. Even this can get tricky, though, since it's not always clear how to define "substantially identical."
Many readers over the years have asked me whether they could get around the wash-sale rule by selling a stock at a loss in a regular taxable account and then buying it back right away for a retirement account.
No, says the IRS. That violates the wash-sale rule.

The Outlook

Sen. Barack Obama, the Democratic candidate for president, proposes raising the top 15% capital-gains rate to 20% for families making more than $250,000, says Jason Furman, the senator's economic policy director. Mr. Furman says the higher rate would apply to only about 2% of the nation's households. Aides also say the Obama plan wouldn't raise any taxes on couples making less than $250,000 a year, nor on any single people with income under $200,000 -- not income taxes, capital-gains taxes, dividend or payroll taxes.
In contrast, Sen. John McCain, the Republican candidate, strongly opposes raising capital-gains tax rates. He also has called for retaining the current federal income-tax rates and believes that raising taxes in these troubled economic times would be exactly the wrong economic prescription.
Some investment advisers think Sen. McCain, if elected, eventually would compromise with a Democratic-controlled Congress on a higher capital-gains rate.

Should you sell winners to take advantage of this year's low rates? Several investment managers say it's premature to act now, unless you'd planned to sell those stocks anyway, because there's uncertainty about how the elections will come out -- and what the effective date of higher rates might be.

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