COVID-19: Should You Recognize Your Capital Losses Now?

Bernie Kent, JD, CPA, PFS | March 24, 2020

For several years many taxpayers have not had to think much about capital loss recognition. They have seen their portfolios grow substantially and may have had few stocks or mutual funds which had declined in value. The situation for many taxpayers has changed dramatically in the last three weeks. For the first time in years, investors are seeing red ink when they review their portfolios. Is this an opportunity for you to make lemonade out of the lemons? If you own stocks and mutual funds outside of a retirement plan or IRA, you may be able to save tax dollars by recognizing your losses now. Here are some frequently asked questions and answers.

FAQs

Q. Should I recognize all of the unrealized capital losses I have now? 

In general, you should recognize capital losses to the extent of your capital gains, plus $3,000. Why not more? Any losses in excess of this amount will result in no current income tax benefit. Of course, there is no way of know not whether you will have additional capital gains later in the year—and by then these losses may have turned into gains.

Q. Why shouldn’t I recognize all the losses I can? 

There is hardly any tax advantage (or disadvantage) to creating a capital loss carryforward, as will be discussed more fully below. However, if you recognize capital losses, there are likely to be undesirable nontax consequences:

First, there may be trading costs, both commissions and/or bid/ask spreads.

Second, in order to recognize the losses, you must not acquire the same or substantially identical security within 31 days before or after your sale. The sale of part or all of your stock portfolio changes your asset allocation.  You could buy similar, but not identical securities and sell them after thirty days. However, you may not do as well with your “second choice” investments as with your first choice. Today In: Taxes

Third, there could be a time lapse between selling one portfolio and acquiring another. While the time-lapse could work in your favor, it is one more variable to consider before taking losses that provide no current tax benefit.

Finally, in the event that your new investments skyrocket in value (in excess of your capital losses), you will have to wait a year to sell or be stuck with higher-taxed short-term capital gains.

If your unrealized capital losses are in no-load mutual funds, the first and third points above would not apply (unless you are subject to a redemption fee).

Q. What if I am holding stocks or mutual funds that I want to sell but don’t want to pay the income tax on the capital gains?

This is an excellent reason to recognize the unrealized capital losses in your portfolio to reduce or eliminate the capital gains tax.

Q. If I don’t realize the unrealized losses now, they will go away in the future as the investments increase in value. Why should I give up the opportunity to use these losses in the future? 

As to any particular investment, you are not giving up the loss by not realizing it currently. When you recognize capital losses and repurchase securities in 31 days, you now have a lower tax basis in your investment. This will cause a larger gain when the investment is sold, offset by the capital loss previously recognized. If instead of selling now and recognizing the capital loss, you retain the investment; then you will retain the high tax basis of the original investment to use at the time of sale. In either case, you will recognize the same net gain or loss upon ultimate sale. The only difference in the total gain or loss between holding the investment and selling it this year is any change in the value of the asset that occurs between this year’s sale and the subsequent repurchase.

Q. Why not stockpile capital losses to use against future capital gains? 

There is generally not much benefit or detriment to stockpiling losses now. If you have high portfolio turnover, you will likely recognize the losses or have smaller gains by selling the securities in the normal course. For example, if your entire portfolio turns over before the end of 2020, stockpiling losses will have the same tax result as is otherwise achieved by not selling this year.

In a low turnover portfolio, it may be several years before capital gains are generated. In this case, it may be possible to find other losses in the future to deal with whatever gains may occur.

But there’s always an exception. In some situations, stockpiling might be a useful strategy. Take for example a situation where all three of the following expectations exist:

  1. There is a likelihood that capital gain will be recognized in 2020;
  2. The current losses in securities will be eroded due to price increases; and
  3. The proceeds from the sale of the loss securities that are sold now are used to repurchase securities that are not sold at gains later in the year.

If all of these factors exist, the “sell now” strategy would result in the acceleration of the use of capital losses. 

Q. What are some of the other situations in which it may not be desirable to recognize capital losses to offset long-term capital gains? 

Taxpayers who are in the 15% tax bracket pay no federal income tax on their capital gains to the extent that their taxable income does not exceed $80,000 on a joint return, $40,000 on a single return, or $50,400 filing as a head of household in 2020. There may be state income tax due on the capital gain. Taxpayers in the 15% bracket who pay no income tax on their recognized long-term capital gains would be better off not taking capital losses since the capital losses would be offsetting nontaxable income (except to the extent of a state tax benefit or the $3,000 which can be applied against ordinary income).

Some taxpayers have long-term capital gains that exceed their taxable income due to ordinary losses or itemized deductions. Careful analysis will be required to maximize the benefit of capital losses. Generally, it will not be desirable to offset the full taxable income.

Rules governing capital gain recognition

So that you have a more complete understanding of these issues, the tax rules governing the Federal income tax on capital gains are as follows.

Tax rates on capital gains

A long-term capital asset is one that is held for more than one year; otherwise, the gain or loss on sale will be short-term. The tax rate on long-term capital gains depends on the taxpayer’s taxable income. Married couples filing a joint return pay a 20% tax rate on long-term capital gains to the extent that their taxable incomes exceed $496,600 in 2020. The threshold for the 20% bracket for Single and Head of Household status is $441,450 and $469,050. Taxpayers with modified adjusted gross income (“MAGI”, which is higher than taxable income) over $250,000 (Joint) or $200,000 (Single or Head of Household) are subject to the 3.8% tax on net investment income, which includes capital gains. Thus the maximum Federal income tax on long-term capital gains is 23.8%. For short-term capital gains, the Federal income tax rates top out at 40.8% (37% + 3.8%). State income tax would further increase these rates.

Married taxpayers filing a joint return pay a 15% tax on long-term capital gains to the extent that their taxable income is between $80,000 and $496,600. For single tax filers the 15% rate applies to taxable income between $40,000 and $441,450 (head of household filers, $53,600 and $468,050). To the extent of taxable income below this level, there is no Federal income tax on long-term capital gains.

Rules For Applying Capital Gains And Losses

As you can see, there are many nuanced answers to the question of whether to recognize your capital losses. You should consult their financial and tax advisers regarding your individual circumstances.

Written by:

Bernie Kent, JD, CPA, PFS

Chairman, Schechter Investment Advisors // Senior Advisor

Bernie Kent is Chairman and Senior Advisor at Schechter Investment Advisors in Birmingham, Michigan. Previously, Bernie was the Midwest Regional Partner in charge of Personal Financial Services for PricewaterhouseCoopers LLP, where he advised more than 25 CEOs of New York Stock Exchange-listed companies as well as 25 families with more than $100,000,000 of net worth.