Sure, the capital gains tax rules are complicated. But if you use them to your advantage, you can significantly cut your tax bill. You do that by selling some of your losers to offset gains. Simple enough, right? Well, it gets tricky when you have both short-term and long-term gains and losses. But we'll try to make it as straightforward as possible.
Long-Term Vs. Short-Term
The first step is to separate your short-term capital gains and losses from your long-term gains and losses. That's because long-term gains are taxed at those lower capital gains rates you hear so much about, while short-term gains are taxed at your regular rate (which can run as high as 35%).
Short-term investment assets are those you've held for one year or less (not less than one year, as you commonly hear). And long-term investments are those you've held for more than one year. For purposes of meeting the more-than-one-year rule, your holding period is considered to begin on the day after you acquire the investment asset. It ends on the day you sell. In effect, you don't count the day you buy. But you do count the day you sell.
For example, say you buy 100 shares of Cisco (CSCO) on Nov. 15, 2004. Your holding period starts on the 16th. If the shares go up and you want to take advantage of the lower tax rate on long-term capital gains, you can't sell before Nov. 16, 2005 -- exactly a year and a day after your holding period began.
The Netting Rules
Your next step is to add together all your gains and losses. First, you net your short-term gains and losses -- that is, you calculate each individual gain or loss by subtracting the purchase price of the securities (including commissions) from the sales proceeds net of commission. Then just sum everything up. You'll come up with an overall net short-term gain or loss figure. Next, you net your long-term gains and losses in the same fashion. You'll end up with either a net long-term loss or a net long-term gain.
Now you need to net your short- and long-term figures to come up with a final tally. This is where it gets really complicated. And if you have both short and long-term gains and losses, deciphering what it all means is enough to make your head feel like you just took a couple of spins on the Lightning Loops roller coaster at Great America.
But our table below will help you untangle the snarl. Simply find the intersection of your short-term and long-term scenarios. You can then see what this means for your tax bill.
|The Netting Rules|
|No Long-Term Action||Net Long-Term Loss||Net Long-Term Gain|
|No Short-Term Action||N/A||You can deduct up to $3,000* of the loss against other income (salary, interest, etc). If loss exceeds $3,000* the excess caries over to next year and is considered a long-term loss.||Taxed at favorable rates.|
|Net Short-Term Loss||You can deduct up to $3,000 of the loss against other income (salary, interest, etc). If loss exceeds $3,000 the excess carries over to next year and is considered a short-term loss.*||You can deduct up to $3,000* against other income. You use up your short-term loss first in applying the $3,000 limit. Any unused amount carries over to next year as a short-term loss. Any unused long-term loss carries over to next year as a long-term loss.||If long-term gain exceeds short-term loss, the net gain is considered a long-term gain and taxed at favorable rates. If short-term loss exceeds long-term gain, the overall loss is considered short-term, which means you can deduct up to $3,000* against other income, and then carry over any excess to next year.|
|Net Short-Term Gain||Net short-term gain taxed at regular rates.||If short-term gain exceeds long-term loss, the net gain is considered a net short-term gain and taxed at your regular rates. If net long-term loss exceeds short-term gain, your overall loss is considered long-term, which means you can deduct up to $3,000* against other income, and then carry over any excess to next year.||Short-term gain = regular rates. Long-term gain = favorable rates.|
*If married and filing separately, the deduction limit is $1,500.