Many investors take care to wait for a gain to become long-term before selling. By doing so, they benefit from the relatively low 15% capital gains tax. Here we take another look at when to sell stock.

Delay recognition of all capital gains, even long-term gains

Once the market value of a stock position rises above its cost basis, an investor has an unrealized gain. When she sells the stock, she will realize the gain and incur a capital gains tax.

In November 2009, she had an unrealized $10,000 long-term gain. Rather than recognizing that gain in 2008, she waited until February 2010 to sell the stock position.

She has delayed a $1,500 tax, $10,000 times 15%, by one full year: April 2010 to April 2011. By postponing the tax, she can invest the $1,500 for a year and earn $75, assuming a 5% return.

Unrealized gains are even more valuable

An unrealized gain is subject to a potential, future tax. Just when that tax becomes payable is at the discretion of the investor.

The ultimate purpose of investing is to preserve wealth over time. An investor need not sell an unrealized gain. By holding the gain, the gain will compound its return and grow like a tax-deferred account, such as an IRA.

In a sense, the investor can enjoy the benefit of the compounding effect of unpaid deferred tax. If and when she needs to withdraw the money from the portfolio, she may choose to realize the gain. For many investors, that day will come during retirement.

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.

Almost one year ago, on September 24, 2008, an investor bought 200 shares of stock at a price of $60. Today, the latest quote for the stock is $45. This drop of $15 gives her an unrealized short-term loss of $3,000.

Tax loss selling at year-end

Many investors review their portfolios before the end of each year. Because capital losses offset gains, some sell stock at that time to realize losses for the current tax year. In fact, some academic studies credit this practice of selling for part of the so-called January effect.

She may hope that between today and the end of the year, the stock price may rise above $45. Then again, it may not. What is certain is that 10 days from now (September 25, 2009) the basis of the stock will become long-term. If she sells the stock for a loss in December, she will realize a long-term capital loss for the 2009 tax year.

Tax loss harvesting year-round

An earlier post showed the tax savings advantage of a short-term loss relative to a long-term loss. By waiting until December to sell, she will have missed the chance in September to realize a short-term capital loss.

Investors purchase stock at all times of the year. This means that the holding period for stock purchased within the last twelve months will also change from short-term to long-term throughout the year.

By making a habit of taking capital losses in December, an investor risks having a number of long-term capital losses. Taking those losses earlier in the year will help avoid that mistake.

An earlier post mentioned that the holding period for a capital gain affects its tax rate. Short-term capital gains get taxed just like ordinary income. This rate can rise as high as 35% for taxpayers in the top bracket. For long-term capital gains, the tax rate is much lower: 15%.

The huge cost of a short-term gain

Eleven months ago, an investor bought 300 shares of stock at $40. The latest market price for the stock is $50. Her $12,000 investment is up 25% and is now worth $15,000. If she sells now, she has a $3,000 short-term capital gain.

In the top tax bracket, the gain would incur a tax of $1,050 ($3,000 times 35%). Subtracting the tax leaves an after-tax gain of $1,950. Instead of being up 25%, her after-tax return has fallen to about 16%.

Save tax if a long-term gain is near

She might wait a month or so before selling. By doing so, she does risk a fall in the market price. But after holding the stock more than a year, she may get another chance to sell the stock at $50. Such a long-term gain would have a tax of $450 ($3,000 times 15%).

Holding the unrealized gain until it became long-term has saved $600 in tax ($1,050 minus $450).

This $600 in after-tax savings amounts to 20% of the $3,000 before-tax gain. When a long-term gain is imminent, one should carefully consider the cost of selling too soon. In other words, taking a short-term gain could cost an investor 20% of their before-tax return.

Note that the Tax Increase Prevention and Reconciliation Act of 2005 extends the 15% rate for long-term capital gains only through December of 2010. Beginning in 2011, long-term capital gains will incur a 20% tax rate.

An investor may purchase a company’s stock at various times and in varying quantities. When part of that stock is later sold, the capital gain is the difference between the sale amount and the cost basis of the stock.

If multiple purchases occurred, the IRS considers the default cost basis to be the amount paid for the stock purchased first. This is also known as FIFO, or first-in, first-out. In a taxable portfolio, relying on FIFO cost basis may raise your capital gains tax. This can do real damage to your after-tax return.

Capital gain using FIFO

Six months ago an investor bought 200 shares of stock for $27 per share. Three months later she bought 200 more shares of the same stock for $33 per share. Today she sold 200 shares at $30. The sale amount is $6,000 (200 shares times $30).

Using FIFO, the cost basis of the stock purchased first is $5,400 (200 shares times $27). The capital gain, sale amount minus cost basis, is $600. This short-term gain is taxed at the marginal rate of ordinary income. With that rate at 35% for many investors, the tax is $210.

When is FIFO cost basis not the right choice?

Using FIFO is easy, and most tax software uses it as a default for stock cost basis. If investors had no other choices for cost basis, this would not be a problem.

But, they do. A different choice would have been to sell the stock purchased later at $33. The cost basis for the later purchase is $6,600 (200 shares times $33). Rather than a gain, the sale would realize a loss of $600. Instead of paying tax, the loss would offset other gains or ordinary income and lower her tax by $210.

By selling the stock bought later, she lowered her current year tax burden by a net $420.

Minimize gains by selling the stock with the highest basis

The change from a costly taxable gain to a loss happened by choosing not the later, but rather the higher cost basis. HIFO, or Highest-In, First-Out, cost basis takes a smaller gain now and defers the larger gain into the future.

In both cases, what remains is a stock position of 200 shares worth $6,000. The differences are the current year tax and the unrealized gain.

With FIFO, the remaining cost basis is from the later purchase, or $6,600. The investor owes $210 in tax and is sitting on an unrealized loss of $600.

Using HIFO, the investor has lowered her tax by $210 and holds an unrealized gain of $600. The lower tax provides $420 more for reinvestment. Further, she may choose not to sell that stock for a number of years, thereby deferring the tax.

Opting out of FIFO cost basis for stock sales

To repeat, the IRS considers FIFO the default cost basis for stock sold. To use HIFO, an investor must make an adequate identification of the stock being sold. Some call this method specific identification.

An investor has no control over market movements, but she can control when she sells stock. By also pinpointing what to sell, she gets a new tool to lower her tax and raise her after-tax return.

For taxable portfolios, after-tax return can be much lower than before-tax return. One reason: short-term capital gains incur the same tax rate as ordinary income. For investors subject to the top 35% marginal tax rate, a short-term gain brings on a tax that lowers its return by 35%.

To put that into numbers, the tax cost on a $10,000 short-term gain is $3,500. That lowers its after-tax gain to only $6,500.

Unequal tax on investment gains

The tax code provides chances to reduce taxes, since not all investment gains are taxed equally. Long-term capital gains get a more favorable 15% tax rate. At $1,500, the tax cost of a $10,000 long-term gain is $2,000 less than that of a similar short-term gain.

One should note that other costs, such as trading commissions or management fees, do not even begin to approach this ‘favorable’ 15% rate.

Recognizing losses to offset gains

For a portfolio having the gains described above, the capital gains tax would total $5,000 ($3,500 plus $1,500).

Suppose that this portfolio also had stock positions with unrealized losses of $10,000 short-term and $10,000 long-term. If the investor were also to sell those positions, the realized losses would offset all of the gains. Having no net capital gain, instead of a $5,000 tax, the tax would be zero.

In this case, selling stock at a loss has preserved some of the investor’s wealth.

Figuring capital gains at the end of the year may not result in the lowest tax

Some people wait until tax season to tally their capital gains. Tax preparation software does a great job with this. So do tax preparers. Both methods should result in the same capital gains tax as reported on the Schedule D. Why?

The net capital gains are determined solely by the actual portfolio trades. Unless the losses were already taken, no realized losses would exist to offset the gains and lower the tax. Neither the expertise of an accountant, nor the ‘intelligence’ of any software, can change the realized net gains.

Consider the tax impact before making a trade

All closing trades change an investor’s net capital gains. Throughout the year many trading opportunities arise as a result of unforeseeable market action. Not all investors know the amount of their total gains when they place an order to sell stock. Those who do know have a chance to make a trade that does not expose the portfolio to avoidable tax.