Most investors have paper losses after more than two years of a vicious bear market. Even though tax losses might not be valuable for years, you should take them now.
When you sell a security at a lower price than you paid for it, a capital loss results. Unfortunately, the tax code permits no more than $3,000 worth of net capital losses to be deducted against ordinary income each year. Unused losses can be carried forward indefinitely, deductible at $3,000 per year.
If that’s the case, why bother taking $10,000 or $20,000 worth of capital losses? Because capital losses from stocks can offset taxable gains from other activities, such as selling a business or an investment property.
In addition, you might have a highly-concentrated portfolio, made up largely of one stock that was acquired a long time ago, at a low price. Taking losses on other positions may allow you to sell some of those low-basis assets and reinvest elsewhere, to reduce overall risk, without triggering taxable gains.
Moreover, even in the current climate, taxable gains might result from rebalancing your portfolio. You might be taking gains on small-cap value stocks, which have performed well the past two years, and harvested losses can be used as an offset.
Suppose none of the above reasons for taking gains this year applies to you. Taking excess losses still may make sense. If you have net losses in excess of $3,000 this year, they can be “banked” and carried forward indefinitely, to offset future gains.
When the stock market recovers, you’ll be able to take gains more freely. That is, at some time in the future, returns will turn positive and you will have more flexibility if you can realize gains yet avoid paying taxes, thanks to suspended losses held in inventory.
What’s the downside of taking capital losses? You’ll incur trading costs. For no-load mutual funds, that’s not an issue. If one growth fund falls in value, there’s no cost to selling that fund and reinvesting in another growth fund, banking the realized loss.
The same isn’t true for load funds and individual stocks, where commissions come into play. Generally, you should start looking at a tax loss once a stock falls 10 percent. For illiquid stocks, the threshold is greater but you might begin thinking about loss harvesting once the price falls by 20 percent or more. In any case, the amount of the loss should be enough to justify the transaction costs.
