A blog about stock portfolio management

Imagine an optimal Schedule D

June 04, 2012

What should an investor do when a stock has a loss since its purchase? In the hope that the stock may recover, some investors continue to hold the loss.

Now that the tax season is winding down, taking a look at your 2009 tax return could provide some fresh context for this situation.

IRS Form 1040 booklet

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.