Use Capital Losses to Take Advantage of Bad Investment Performance
Unfortunately, with the recent stock market activity, many investments are much lower than the price at which they were purchased.While this is not desirable, there is a little bit of a silver lining that can be gleaned from the investment losses. You can sell your position, as long as it is held in a taxable account, and deduct a portion of that loss from your income for the year. Here is the definition of a capital loss, followed by a short example of a strategy to put in place to take advantage of a bad situation.
What is a Capital Loss?
A capital loss is a decrease in the value of an asset below its purchase price. Capital loss reduces a taxpayer's income tax. If you've held the asset more than one year, the capital loss is long-term; if you've held it for one year or less, it's a short-term capital loss. A capital loss is realized once the capital asset is sold at a loss; until the asset is sold, the capital loss is unrealized. Once the capital loss is realized, it will go to reduce a taxpayer's capital gains tax.
If the capital loss is greater than the IRS preset limit (i.e.: $3,000 in 2007), the capital loss over such IRS preset limit (i.e. carryover capital loss) can be carried to the next tax year. Note that if the carryover capital loss is a short-term capital loss, it will go to offset a short-term gain in the next tax year, not a long-term gain, and vice-versa.
How to take advantage of a Capital Loss
The best way to take advantage of a capital loss would be by liquidating the position, therefore locking in the loss. Next, if you would like to keep your investment in the market, you would be well served by purchasing a similar company in the same industry. Logic would dictate that as the market rebounds, the similar position will mimic the performance of your prior holding.Ex. If you bought 1000 shares of Home Depot at $10 a share, but it is trading at $5 a share. Your initial investment is down from $10,000 to $5,000.
You would sell the Home Depot stock, therefore locking in the $5,000 capital loss that can be deducted from your income for $3,000 per year.
Next, you would purchase Lowes with the $5,000 with the assumption that both companies, being in the same industry, would perform similarly as the economy recovers.
In a perfect world, you would get back to your $10,000 initial investment with Lowes at about the same time as if you had just held onto your Home Depot stock. However, you have now locked in a $5,000 Capital loss, which can be deducted from your ordinary income.
Hopefully, an investor can participate in the market recovery, as well as locking in a valuable tax deduction over the foreseeable future.
Taking a capital loss, as we did in this example, is something you can do to turn a bad situation into something positive.
