Tips on Selling Money-Losing Investments

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Dec. 31 is a long way off, but it’s not too early to start thinking about year-end tax maneuvers like selling money-losing investments. The stock market’s recent downturn may provide some opportunities that might not be there if you wait until the last minute and the markets rebound.

Decisions you make now, such as which of the four accounting methods to use if you sell just a portion of a holding, could affect your tax bill for the year and determine the accounting method you must use in the future.

The idea is to “realize” or “harvest” losses on investments that are now worth less than you’d paid. It generally doesn’t make sense to do this if you think the investment will rebound and you want to own it for the long term. But when an investment turns into a disappointment and it’s time to say goodbye, make the most of the tax benefit by moving your money to something more promising. (Investors also may need to sell winners from time to time, to raise cash, diversify holdings or rebalance a portfolio.)

If you’re of two minds, it could make sense to just trim the holding rather than bail out completely.  There are a variety of reasons why you might want to sell just part of an investment – a portion of stocks or mutual fund shares, for instance. In that case, you’ll have to decide which of four methods to use, each with its own combination of tax benefits and paperwork hassles.

Once you’ve picked an accounting method, you’ll generally have to stick with it for subsequent sales of the same investment, such as a block of mutual fund XYZ. You can, however, use different methods for different holdings.

The most common method, assumed by most brokerages and fund companies unless the customer orders something else, is the average-cost, single-category method. It calculates the average you cost you paid per share.

Your taxable gain or loss is figured by subtracting the per-share cost from the per-share sales price. This method assumes you sold the shares you’d owned the longest. Most financial services firms use this method on the 1099 forms sent in January, detailing sales for the previous year, making record keeping a cinch.

Next is the average cost, double-category method. Your shares are divided into two groups, those owned for a year or less and those owned longer. An average cost is figured for each group, and you choose which group from which to sell.

On a profitable investment, you might choose to sell those owned longer, as the long-term capital gains rate is capped at 15%, while the short-term rate can go as high as 35%. With a loser, you might sell from the short-term group, because the tax deduction would be bigger if you can use it to offset short-term gains on another investment you sold.

The third method is first-in, first out, and the IRS assumes you used this unless you report another method. It assumes every sale is done from among the shares owned the longest, so you’re likely to sell those subject to long-term capital gains or losses if you’ve owned shares at least a year. On the other hand, shares you’ve owned the longest may have enjoyed the biggest gains, giving you a bigger tax bill than you’d pay on shares bought later for higher prices.

The fourth method, specific identification, is the most flexible. In ordering the sale, you tell the brokerage or fund company which shares to sell, such as those bought on a specific date at a certain price. This allows you to choose shares that will produce the smallest tax bill – those for which you paid the most and, possibly, also owned for at least a year – or those offering the biggest tax loss – those you paid the most for but owned for a year or less.

The specific identification method, however, requires you do a lot of record keeping, as you’ll need to know purchase date and price for all shares you sell in the future. Also, you must tell the financial firm this is what you are doing. You cannot wait until you do your tax return. The IRS requires that you have written confirmation of the order from the firm.

Obviously, there’s a lot to consider, as both the holding period and the size of the gain or loss will determine the tax consequences of any sale, so it’s best not to wait until the end of the year. Your fund company or brokerage probably has a guide to these issues on its website, and the IRS has details in Publication 564.

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