How to Turn Investment Losses into Valuable Assets

Prices for stocks, bonds and many other investments are tumbling, and that means many investors have or soon will have losses in their accounts.

Losses in taxable accounts can be minimized and turned into assets by knowing the tax rules and using the best strategies for your situation.

In a taxable account, an investment loss is a capital loss. You realize a capital loss, meaning it is reported on your income tax return, by selling the investment. If the investment was owned one year or less, the loss is short-term.

Otherwise, the loss is long-term. There are several steps to reporting capital losses on your tax return and reaping some benefits from them.

First, realized capital losses are deducted against capital gains realized during the year. Short-term losses first are deducted against short-term gains, and long-term gains and losses offset each other. Second, any net losses are deducted from any net gains for the year.

For example, an investor might have more short-term losses than short-term gains, so there is a net short-term loss. The investor’s long-term gains might exceed long-term losses for the year, so there’s a net long-term gain.

The net short-term loss then is deducted against the net long-term gain. Third, if the net losses for the year exceed the net gains, the excess losses can be deducted against other income on the tax return. But only up to $3,000 of excess capital losses can be deducted against other income each year.

Fourth, any excess losses (those that exceed gains for the year and the $3,000 deduction limit) are carried forward to future years to be deducted in the same way. The net losses retain their character as net short-term or long-term losses when deducted in future years.

Those tax rules and their effects are important to consider when deciding whether and when to sell an investment that’s showing a paper loss. Shrewd use of the tax rules can decrease the pain of a net loss by sheltering investment gains or other income from taxes.

Of course, investment factors should be the prime movers of your decisions. If an investment thesis turns out to be wrong, sell the investment and reinvest the proceeds in something with better prospects. You also should sell if it appears that it will take too long for an investment to turn around and there are better opportunities for your capital.

Some people decide they don’t want losses on any investment to exceed a certain percentage, sometimes known as the pain level, even if the investment is likely to turn around eventually. When an investment reaches your pain level, sell.

Otherwise, you should have a tax-loss harvesting strategy for your taxable accounts, monitor the accounts for opportunities all year and make adjustments to the strategy, as needed.

The general rule in a tax-loss harvesting strategy is to sell investments with meaningful paper losses. Selling an investment each time it dips below your purchase price isn’t worth the time. Instead, decide on a percentage loss that will trigger a tax harvesting sale.

When you sell an investment and realize a capital loss, that loss is an asset you have in reserve or have banked. Another general rule is that it’s better to recognize a loss when you’ve held the asset for one year or less. That makes it a short-term loss.

It’s available in the future to deduct against any short-term gains. Short-term gains are taxed as ordinary income, so they face a higher tax rate than long-term gains. Having some short-term losses in the bank means that in the future if an investment surges soon after you purchase it, you don’t have to hold the investment for more than one year so that it matures into a tax-favored long-term gain.

There might be a lot of market risk in waiting. Instead, you can sell the investment and use the short-term capital loss to make all or most of the gain tax free. Even if you don’t have taxable capital gains this year and the outlook for the markets makes it appear there won’t be gains for a while, realized losses are valuable over the long term. In a worst-case scenario, realized capital losses make up to $3,000 of income tax free this year and every year until the losses are exhausted.

Over the long term, after the markets recover and investments appreciate again, you’ll have losses in reserve that reduce or eliminate the taxes when you realize those gains. Consider any costs of tax-loss harvesting before realizing losses.

There might be trading costs, though that’s often not the case today. There also might be a portfolio or strategy cost, because the risk and return of the portfolio might change when the investment is sold.

The benefits of tax-loss harvesting might decline when an investor already has a substantial amount of capital losses in reserve. That’s especially true when the investor is adopting a more conservative investment strategy that makes it less likely there will be sufficient capital gains in the future to absorb the losses.

Capital loss carryovers don’t expire as long as you’re alive, though they can’t be passed on to your estate or your heirs. They’re available in the future when you take gains, rebalance a portfolio, sell an asset to generate cash, or take other actions that generate taxable gains.

Having some carryover losses can make it easier to sell a winning investment. You can consider only the merits of the investment instead of the potential taxes, because you know the carryover losses will shelter the gain. Some investors with carryover losses use them to increase the tax basis of winning investments they still find attractive for the long term.

The winning investment can be sold, and the gain is fully or partially offset by the carryover losses. The proceeds from the sale are reinvested, and that gives the new investment a higher tax basis than the old investment. If the market rolls over, that loss can be harvested and a new loss put on the books. If the market doesn’t roll over, when the investor eventually sells the taxable gain will be much lower than if the previous sale hadn’t occurred.

That strategy might be better than using a small amount of carryover losses each year. After a losing investment is sold, the sale proceeds will be reinvested. It is important to know about the wash sale rules to avoid losing the benefits of recognized losses.

The wash sale rule requires waiting more than 30 days (not 30 days— more than 30 days) to repurchase the investment or a substantially identical one. If you don’t wait long enough, the loss isn’t deducted that year. It is added to the basis of the new investment and effectively is deducted when that investment is sold. The wash sale rule also applies if you bought the substantially identical investment within 30 days before you sold the losing investment.

So, the first rule is to avoid buying a substantially identical investment within 30 days of selling an investment. You can buy an investment within 30 days that isn’t substantially identical. For example, you can sell one tech stock and purchase a different tech stock, even one in the same sector. Or you can sell a biotech stock and buy shares in a biotech ETF.

Another action you can’t take is to buy a substantially identical investment in an IRA or 401(k). The IRS ruled some years ago that the wash sale rule is violated when an individual investor sells an investment in a taxable account and within 30 days buys the same investment in an IRA or 401(k). It is one case when the IRA isn’t treated as a separate taxpayer. Here’s a related point.

When you have a losing investment in an IRA, you won’t be able to deduct the loss on your individual tax return. A loss in an IRA is deductible only in the rare case when you fully distribute all your IRAs of the same type (traditional or Roth), and the proceeds are less than your aggregate cost basis in the IRAs.