A blog about stock portfolio management

Costly to offset a long-term capital gain against a short-term loss

December 19, 2011

Short-term losses directly offset short-term gains. Investors can also use the net capital loss to lower their ordinary income by as much as $3,000. In the best case for those subject to the top 35% marginal tax rate, a $3,000 capital loss could reduce the tax due by $1,050. Taxpayers in lower tax brackets see smaller tax reductions, though.

How to dilute the tax reduction value of a short-term capital loss

Suppose that year to date, an investor's portfolio has already realized a net short term capital loss of $3,000. The portfolio also has $10,000 of unrealized long term capital gains.

If she sells stock to realize a $3,000 long-term gain, the short-term loss will offset the gain. This leaves her with zero net capital gain. With zero gain, she has zero capital gains tax due.

Had there been no short-term loss, the $3,000 long-term gain would have incurred a tax of $450 (15% times $3,000). By offsetting the gain, the net short-term loss has also offset the $450 tax. Used this way, the $3,000 loss is 'worth' only $450. She has wasted $700 of the potential value of the short-term loss.

Delay long-term gains to years without short-term losses

The investor might have a better choice in this situation. Suppose she waited until the next year to realize the $3,000 long-term gain. Without a loss to offset the gain, the capital gains tax would be $450 (15% times $3,000). In the prior year, her $3,000 capital loss lowered her tax by $1,050. Looking at both years together, her net capital gains tax would be a negative $700 ($450 minus $1,050). She has recovered the full potential of the $3,000 short-term loss by avoiding its offset against a long-term gain.

Tags: capital-gain, return, and tax