Tuesday, August 9, 2011


The value of many taxpayers’ investment portfolios, both in “regular” accounts and in tax-deferred retirement, education or medical savings accounts, has substantially dropped as a result of the reduction of the rating of the United States from AAA to AA+, or more appropriately because of the actions, and inactions, of the idiots in Congress.

However there is no tax consequence in such a drop for a “regular” investment unless you actually sell the investment at a loss – it is sold for less than it originally cost. And there is no tax consequence whatsoever for the tax-deferred accounts, even if investments within the account are actually sold.

If an investment was worth $10,000 last week, but is now worth only $6,500, your portfolio suffered a $3,500 “paper” loss. However, if the investment cost only $5,000 when it was originally purchased and it is sold for $6,500 there is a $1,500 taxable gain, which, if it was held for one year or more, will be taxed at the federal level at the appropriate special capital gain rate – possibly 0%.

If the investment originally cost $10,000 and it is sold for $6,500 there will be a $3,500 net capital loss. This loss must first be applied against any capital gains of the same category – short-term or long-term – and if there is a remaining loss it is applied against capital gains of the other category. If there still remains a net loss it is deductible, within limits, against other taxable income and the resulting tax savings is based on “ordinary income” rates.

The net capital loss deduction is limited to $3,000 per year ($1,500 if married and filing separately), and has been so for decades. If the $3,500 loss is your only Schedule D activity for the year then $3,000 can be deducted against other taxable income and $500 is carried forward to your 2012 Schedule D. If you are in the 25% bracket this $3,000 loss deduction will reduce your federal tax liability by $750, allowing you to recoup some of your loss.

State tax law differs from state to state. Your $3,000 net federal capital loss may or may not also be deductible on your state tax return. It is not deductible on the NJ-1040.

You should be aware that “capital gain distributions” from mutual fund investments are reported as long-term capital gains on Schedule D and can reduce the net capital loss allowable for deduction.

If you want to take advantage of the $3,500 loss deduction on the drop in your investment, but think that it will eventually go back up beyond the initial cost price and want to hold on to it, you can sell the stock today, recognize the taxable loss, and buy back the same investment after waiting 31 full days. Under the federal wash sale rules, which usually also apply on the state return, you cannot claim a loss on the sale of an investment if you buy back the same, or a substantially identical, investment within 30 days.

The wash sale does not apply if you sell an investment at a gain.

Back when I had a storefront office and the stock market dropped substantially (I don’t want to use the term crashed) many clients came into the office at tax time and complained “I lost $200,000 in my retirement plan!”. They were hoping that they would be able to get some kind of tax deduction for this loss.

I had to disappoint these clients. As I have said in a previous post, like Vegas, What Happens in an IRA (or any other tax-deferred retirement account) Stays in the IRA. Losses within a tax-deferred account are not deductible, whether or not any investments are actually sold.

To be honest, usually the client did not actually lose any money. The value of his retirement account may have dropped by $200,000, but it was still worth almost twice what he/she had contributed to the account over the years via payroll deduction.

There is a way to get a tax benefit for losses in an IRA (not in any employer-sponsored retirement plan) – but only if you withdraw all the monies in all your IRA accounts in one year and the total amount of what you get out is less than what you put in over the years. But that is the subject for another post.



Peter Reilly said...

There is a strategy called "loss harvesting" which can make some sense, but it is not for the faint of heart.

If you have a burned out tax shelter loss harvesting can get you some really good results.

Its a failry limited fact pattern though


Robert D Flach said...


Thanks for the word on "loss harvesting".