Tax Selling

Article written by EricBank

As the end of each year approaches, the opportunity arises to evaluate your portfolio, winnow out the laggards, reap some of the winners and perhaps select new investments. Part of this strategy is tax-related. Let's review the capital loss rules and the special tax breaks available to active securities traders.

Capital Gains and Losses

One thing that distinguishes the tax treatment of investors versus traders is the handling of gains and losses. The capital gains tax rates range from zero to 20 percent, depending on your ordinary tax bracket:

Tax Bracket	Over	To	Capital Gains Rate
10%	$0	$9,075	0%
15%	$9,075	$36,900	0%
25%	$36,900	$89,350	15%
28%	$89,350	$186,350	15%
33%	$186,350	$405,100	15%
35%	$405,100	$406,750	15%
39.60%	$406,750		20%

Figure 1 Capital Gains Rates -- Single Taxpayer

These rates apply to long-term capital gains (on holdings longer than one year) and on qualified dividends. Capital losses offset capital gains and up to $3,000 of ordinary income. You can carry unused losses forward to offset income in future years. Interest income is subject to ordinary tax rates.

Strategy

In a tax-selling strategy, you couple the sale of winners and losers so that the losses offset, and perhaps exceed, the gains. If you don't have enough losses to fully offset your gains, you might be able to use carryover losses from previous years. You also might hold off on selling winners until early in the new year to avoid income in the current year.

The wrinkle in this strategy is that any short-term capital gains are taxed at normal rates, which makes pairing to losses even more important. If you sell holdings consisting of long-term and short-term tax lots -- some of the purchases occurred more than a year ago -- you can juggle the selection of long-term and short-term gains to get the maximum benefit from your capital losses, especially if you also have ordinary income.

Mark-to-Market Rules

If you are an active securities trader, you can choose mark-to-market accounting, which will change the way you report gains and losses. Recall from our blog on wash sales that the IRS will consider you an active securities trader if:

.   You seek profits from daily market movements in prices

.   Your activity is substantial

.   Your activity is continuous and regular

As we have pointed out, MTM accounting treats your holdings as if you sold and repurchased them at the closing market prices on the last trading day of the year, thereby realizing gains and losses. If you take this route, your gains and losses are subject to ordinary tax rates, not capital gains rates. The main benefit from this rule is that you are not bound by the $3,000 cap on applying current year trading losses to ordinary income, as you would be by capital losses. Your trading losses are business losses and you report them as such. Of course, MTM accounting negates tax-selling strategies, since you, in effect, sell everything on the last day of the year.

One other benefit is that you can deduct investment interest expense in full -- it is not capped by investment income. This is useful when you have other sources of income in addition to your trading income, because you can offset these as well.