Capital Loss Whipsaw

A whipsaw is a situation where you lose on both ends. When it comes to taxation of investments, many disasters relate in one way or another to a capital loss whipsaw. This is a situation where you have to report income or gain from a profit that later gets reversed into a capital loss you can’t deduct.

Lose, then gain: not so bad

If you actively trade your investment account you’re likely to perform well during some periods and poorly during others. That’s just the nature of the game. You don’t have a tax problem if you suffer losses in one year and recoup them the following year. Any portion of the loss that remains unused in the bad year carries over to the next year when you can use it against your gains. You’d prefer not to have the losses in the first place, but at least in this situation your tax results will reflect your trading results. Overall you have zero profit, and you’ve been taxed on zero profit.

Gain, then lose: tax disaster

Turn that situation around and you have a real problem. Suppose your trading produced gains of $100,000 one year but you lost the same amount the following year. You have to pay tax on the gain for the first year, even if the entire profit has disappeared by the time you file your tax return. What’s worse, the $3,000 annual capital loss limitation will prevent you from claiming more than a small fraction of the loss in the later year. You have a capital loss carryover to the year after that, but this may be small consolation. Overall you have zero profit for the two years of trading, just as in the previous example, but in this case you’re out of pocket for a big tax bill in the first year, with no significant offset in the next.

• Unused capital losses carry forward to the next year but you aren’t allowed to carry them back to an earlier year.

Ordinary/capital whipsaw

If you receive stock as compensation, you can be hit with a capital loss whipsaw even when selling shares within the same year you report the income.

Example: You exercised a nonqualified stock option, paying $20 per share for 1,000 shares when the stock was worth $80. The stock price collapsed, and you sold the stock later the same year at $40.

Your actual profit is only $20,000, but you have to report $60,000 as compensation income. The sale produces a capital loss of $40,000, but unless you have capital gain from some other source, you can deduct only $3,000. Overall you pay tax on $57,000 even though your economic profit is only $20,000.

Avoiding the problem

There’s no magic solution here: any investment with a good prospect for profit also presents risk of a decline in value. When you’ve incurred a significant tax liability, whether from capital gain or from equity compensation, be sure to set aside the cash you’ll need to cover the tax liability. An unpaid tax liability is a form of leverage that can accentuate any losses produced by your investments.