How to Make a Down Market Work for You

When you hold your investments in a taxable account, you aren’t just fighting the market to make money. You’re fighting the taxman, too.

Unless your income is so low that you fall into the non-taxable bracket, you will owe the IRS taxes on your profitable trades. Depending on where you live, you may owe state and local capital gains taxes as well.

Fortunately, the IRS allows you to offset your capital gains with capital losses. Nobody likes losing money in stocks, but at least the ability to use the loss to reduce taxes is a silver lining.

Two Birds, One Stone

When the market is falling and you want to temporarily reduce your market exposure, it can be a good time to realize your losses and kill two birds with one stone. You reduce your capital gains tax and have more money on the sidelines during a potential market fall.

Say you sell your Apple (NSDQ: AAPL) and realized $10,000 in capital gains this year, but you also sold Halliburton (NYSE: HAL) and realized $9,000 in capital losses. The loss reduces your capital gain by $9,000, so come tax time you will only have to pay taxes on that net $1,000 gain.

If you have more losses than gains in a year, you can claim up to $3,000 of the net loss against other types of income. If you have more than $3,000 in net losses in a given year, the leftover loss can be carried over into future years to offset incomes.

The rule is that you must first use short-term losses to offset short-term gains and long-term losses to offset long-term gains. Then if you still have a net loss (short or long) left over, you can use it to offset gain of the other type.

Beware of the Wash-Sale Rule

If you still like the stock, you can buy it back at a later time. But be sure to wait more than 30 days after you sell it to buy it back. The IRS has a rule against wash sales, which says that if you buy the same or a substantially identical security within 30 days of the sale of a stock that resulted in a loss, you cannot claim a loss on that sale.

Note that “within 30 days” means 30 days before and 30 days after the sale. This means the wash-sale window is actually 61 days wide, centered around the day you sell the stock.

“Substantially identical” is a somewhat gray description. If you buy a different class share in the same company—e.g., GOOG vs. GOOGL—or if you buy a call option on the stock you sell, the IRS will call that a wash sale.

On the other hand, buying an index exchange-traded fund sponsored by a different company—e.g. SPY vs. VOO—may or may not raise a red flag. The IRS hasn’t explicitly said such a move violates the rule, but it’s best not to test your luck.

To play it safe, buy a different stock in the same industry. For example, if you sell HAL for a loss, you could buy another oil-services stock in Schlumberger (NYSE: SLB).

Deferred, Not Lost

Also, note that even if you violate the wash-sale rule, you don’t permanently lose your ability to claim a loss. You simply defer that benefit to the future. The loss from selling the first lot is tacked onto the cost basis of your new purchase, so when you sell those new shares (without violating the wash-sale rule) down the road you would still be able to get credit for the original loss.

Let’s say you bought 100 shares of AAPL for $205 and you sold them for $195, for a loss of $1,000, or $10 per share. But then within a week you bought back 100 shares at $200 each. You won’t be able to claim a loss on the first sale, but your cost basis for the new lot would increase by $1,000 to $21,000, or $210 per share. When you eventually sell those new 100 shares, you get the credit for the original $1,000 loss in the form of a higher cost basis.

Opportunity Cost Risk

As mentioned earlier, when the market is falling, it can be a good time to harvest those losses. Ideally, if you are selling a stock purely to take credit for the loss and you want to buy it back later, you can get it for a lower price 31 days later.

The risk, of course, is that instead of falling, the stock rallies. You will miss out on that gain.

If you buy a similar stock during the waiting period, things could work for or against you—it depends on whether the second stock outperforms or underperforms the first time.

That’s the beauty—or frustration—of the stock market. There are no sure things.

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