Yesterday, the BP ADR closed at $29.20. You have fallen into deep water, with no clear vision of the horizon.

Your 200 share position in BP consists of two tax lots. The first, year-old tax lot has an unrealized loss of about $2,100 (-$21 times 100 shares). For the second, more recent tax lot you have an unrealized loss of about $1,400.

Wash sale effect on cost basis

If you sell the first tax lot for a loss, you cannot deduct that loss from your net capital gains. The loss would be disallowed as a wash sale, because you bought substantially identical stock within 30 days prior to the sale.

This is the point where most discussions of the wash sale rule end. But the real damage has only just begun.

To account for the wash sale, you must add the disallowed loss to the cost basis of the purchase that triggered the wash sale. In this case, the second tax lot has its cost basis raised by $2,100 to $6,400. You also change the beginning of the holding period for the second tax lot to the purchase date of the stock sold.

The second tax lot now has an unrealized loss of $3,500, and its holding period began on June 15, 2009. Next week, on June 16, this loss will become long-term.

Avoid a wash sale that creates a long-term capital loss

Before your recent purchase two weeks ago, the first tax lot had an unrealized loss of $700. More significantly, the holding period for that lot was approaching one year. An earlier post pointed out the importance of recognizing short-term losses before they become long-term.

Adding to a stock position which has an unrealized capital loss starts a 30-day wash sale window. During that window, a sale of the stock for a loss will be disallowed. Particularly worrisome is when the window stretches the holding period of a tax lot beyond one year.

Buy and hold could give away a tax break

Each year, taxpayers may subtract up to $3,000 in capital losses from their ordinary income. For those in the 35% tax bracket, this amounts to a tax reduction of $1,050.

Under a buy and hold strategy, an investor may not have sold any stock during 2009. By doing so, he would have avoided paying any capital gains tax.

If this investor’s portfolio had nothing but unrealized gains, he could do no better. Most investors are not that fortunate.

Sell to realize a capital loss and get a tax break

No investor is perfect with their stock picking. Anytime a new stock is purchased, a risk exists that its price may fall.

By selling a stock for a loss, an investor can lower his overall capital gains. If he realizes losses equaling $3,000, he enjoys the maximum tax break.

Offset further losses with capital gains

If the total capital loss exceeds $3,000, the excess is carried forward to the next year. Delaying by a year the benefit of the tax break dilutes its value, due to the time value of money.

One way to avoid a capital loss carry forward is to sell a different stock for a gain. This also provides a convenient chance to improve the degree of portfolio diversification. Overweighted stocks tend to be those with unrealized gains.

Let long-term capital gains wait a little longer

With its tax rate of only 15%, some investors might choose to realize a long-term capital gain. As discussed in an earlier post, unless the investor is retired and no longer adding money to the portfolio, taking such a gain is unnecessary and costly.

Get the maximum tax reduction on Schedule D

An individual’s Schedule D could have a net short-term loss of $3,000, with zero long-term capital gains. In this case, he will benefit from the maximum tax break for capital losses.

If his portfolio has unrealized losses and he reports a smaller loss, or even a gain, he may be just another irrational investor.

Diversification can dampen losses

An investor has decided to diversify by holding 10 stocks in a $100,000 portfolio. To balance the portfolio, he bought equal amounts, or $10,000, of each stock.

After three months, the total value of the portfolio has not changed. Two stocks have dropped 25% to just $7,500. On the plus side, one stock is up 50% to $15,000.

Having that gain to offset the losses shows the power of diversification. Without the $5,000 gain, the overall portfolio value could have dropped to $95,000.

Market action degrades diversification

The relative weight of the $15,000 holding has risen to 15% ($15,000 divided by $100,000). Now, the portfolio is far more sensitive to a price change in that stock.

Both of the $7,500 holdings are underweighted. Due to their small size, they now have less influence on the future performance of the portfolio.

Rebalancing could trade a potential risk for a certain cost

Equalizing the weights would restore the measure of diversification. To begin, he sells one-third, or $5,000, of the $15,000 holding and realizes a short-term gain of $1,670 (one-third of the $5,000 gain). The gain also incurs a tax of $580 ($1,670 times 35%). From the proceeds of the sale, he now has $4,420 in cash.

He then adds to the two $7,500 holdings by buying $2,210 of stock in each. While he has succeeded in balancing the portfolio, its value has dropped to $99,420, due to the tax.

Bringing a single over-weighted stock back to its target weight has cost the portfolio $580. Repeating this action each quarter might present too high a price to keep the stock weighting balanced.

Offset the balancing cost by taking a loss

Instead of adding to both of the $7,500 holdings, he could have sold one of them. Recognizing a $2,500 short-term loss would more than offset the gain.

Better yet, the net loss of $830 ($1,670 minus $2,500) would provide a tax reduction of $290. The tax penalty for rebalancing has just vanished.

Not counting the tax savings, he now has $12,500 in cash from the proceeds of the two sales. With that, he could buy $10,000 in a different stock. To adjust the weight of the remaining $7,500 holding, he could also add $2,500 in stock.

But after considering the lower tax, he would also have $290 to spare.

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.