COLUMN-Tax-loss harvesting and the fiscal cliff don't mix
By Amy Feldman
NEW YORK Oct 22 (Reuters) - With taxes in flux because of the looming expiration at year-end of the George W. Bush-era tax cuts, it is time for investors to play the capital gains and losses game.
A recent Bank of America Merrill Lynch report gauged the prospect of a resolution of the fiscal cliff by year end - with all of its tax consequences - at just 15 percent. Instead, Merrill predicted that the most likely scenario was a multi-stage fix that takes a few tries and a few months to get done.
So while you usually can plan your year-end tax strategy with a look to the following year, this year you have to make your tax moves without such certainty. Because without any action by Congress, the rate on long-term capital gains will rise from 15 percent to 20 percent.
If that happens, high-income earners could actually see their long-term capital gains rate rise to an effective 23.8 percent because of the 3.8 percent Medicare surcharge on investment income that goes into effect in 2013 as part of the health-reform legislation.
Short-term capital gains rates, which are taxed at your marginal income tax rate, would also rise without action by Congress. At the highest tax bracket, short-term capital gains rates could rise from 35 percent, today's top marginal rate, to 43.4 percent, after accounting for the 3.8 percent Medicare surcharge. This makes creating a tax strategy for your investments that much more important.
The basic matching of capital gains and capital losses works like this: Long-term gains (on assets held more than one year and currently taxed at 15 percent) are first matched against long-term losses, while short-term gains (taxed at your marginal income tax rate) are paired against short-term losses. The long-term and short-term results are then matched against each other. If the result is a net loss, you can deduct up to $3,000 against ordinary income, and roll over any extra to offset future years' gains.
By the time Congress decides what the 2013 tax landscape will look like, it will be too late to make changes to your 2012 planning to account for it. And if changes are applied retroactively, "it will be too late to undo your actions of 2012," said Robert Spielman, a partner at accounting firm Marcum.
For investors, that means your year-end tax planning is all about playing the odds and managing the risks. No strategy is certain, but here is how to play some of the what-ifs.
1. If you do not expect your capital-gains rate to change...
Plan like you normally would. While there is lots of talk about planning for higher rates, unless the Bush tax cuts are allowed to expire completely - something that neither presidential candidate says he wants to happen - this may not apply to you. If you make less than $500,000, you are likely to be under the income cut-off for high-income taxpayers, and you might be better off ignoring the chatter, and proceeding with a typical tax-loss harvesting strategy.
That means tallying up your gains and losses to date. Then, if you have losers you were thinking of selling, you would take at least enough to cover the gains and the $3,000 you are allowed to use to offset income.
2. If you think your capital-gains rates will be higher in 2013...
Take gains this year and losses next. That is the better strategy if you are above the income cutoff or if you think the Bush tax cuts will be allowed to expire completely. This is because your capital gains will cost less this year, while your capital losses will be worth more next year.
In this case, you might even want to sell a business or accelerate an installment sale to take advantage of the lower rates while they are still in effect. "For those who will have gains in the future, you would not want to take losses this year," Spielman said. "You'd want to bank them, and use them against income taxed at a higher rate."
If you are thinking ahead, you may then want to buy back the same stock over the coming months in order to reset your cost basis for tax purposes before rates go up. (The so-called wash sale rule, which prohibits investors from taking losses and immediately buying back a similar investment, has no relevance to taking gains and then doing so.)
But keep in mind: In order to keep the same amount invested, you will need to come up with some funds from elsewhere to pay the tax bill.
3. If you are just not sure...
President Barack Obama has called for raising the tax rate on long-term capital gains to 20 percent on high-income earners only (defined as singles who make more than $200,000, and joint filers who make more than $250,000). Republican candidate Mitt Romney wants to keep the capital gains rates low for everyone, and eliminate them completely for less-wealthy taxpayers.
But if you do not know how to bet on next year's rates, do some math. What will you save if you are right? What will it cost if you are wrong? Figure out which scenario would make you less uncomfortable if you turn out to be wrong, and act accordingly. Once you have made your move, don't look back: There is next year to worry about.