When possible, it’s usually better to preserve excess capital losses.
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You’re allowed to deduct capital losses up to the amount of your capital gains plus $3,000. Any additional loss carries over to the next year, when you can use it according to the same rule. Some people — including some experts — think it makes sense to use the loss earlier if you have an opportunity to do so. In most cases that’s a mistake: for tax planning purposes, you’re better off preserving the capital loss carryover.
Your decisions about what to sell, and when, should be driven mainly by investment principles, not tax planning. This is especially true if you hold a large block of a single stock. Normally it’s better to sell some or all of that stock even if you have to pay some tax, because the benefits of diversification generally outweigh the benefit you can get from tax deferral. The discussion on this page assumes investment considerations aren’t strong enough to influence your tax planning strategy.
A Fact Pattern
Let’s set up an example we can use to examine this tax strategy. You review your tax situation in December and find that your capital losses exceed your capital gains by $10,000. If that’s how the year ends, you’ll have a $3,000 capital loss deduction (reducing the amount of tax you pay on wages or other income) and a $7,000 capital loss carryover. You also have some mutual fund shares you could sell for a capital gain of $7,000. Apart from the tax considerations, you’re indifferent about whether to sell the shares now (we’ll call it year 1) or continue holding them for a sale in some later year (year 2 or year 3, for example). Are you better off selling the shares in year 1 so you can use the capital loss now?
No Immediate Tax Savings
There is a tendency to believe you save money on taxes if you use a tax benefit sooner. That isn’t true here, because you aren’t reducing your tax in the current year. You added $7,000 of capital gain and used $7,000 more capital loss, so you have two items that cancel each other out. Your tax bill didn’t go up, but it also didn’t go down. This should be a warning sign about this strategy: you burned up a potential tax benefit (the benefit of using a capital loss carryover) without achieving any tax savings.
Tax Savings Later?
Your strategy of realizing a capital gain before the end of the year produces one potential benefit: it eliminates the need to pay tax on that $7,000 capital gain in a later year. But are you really better off?
Let’s suppose that without this strategy you would have sold your mutual fund shares in the following year (year 2). In that case you would have $7,000 of capital gain — but you would also have a $7,000 capital loss carryover to use against that gain. You would get the same benefit from the capital loss in year 2 as you received in year 1, so the strategy of selling in year 1 still doesn’t produce any benefit.
If we look farther ahead, we begin to see a disadvantage for selling in year 1. For example, suppose you would have ended up holding the mutual fund shares three more years, selling in year 4. One possibility is that you don’t have any capital gains or losses in year 2 or 3. In that case, a capital loss carryover would have allowed you to claim deductions of $3,000 per year in those years. Those deductions count against wages or other ordinary income, which is usually taxed at higher rates than capital gains. The strategy of selling shares in year 1 deprives you of the ability to claim these valuable deductions.
Another possibility is that you’ll have a capital gain in year 2 from some other source. If you have a capital loss carryover, you can use it to reduce or eliminate the tax on that capital gain. If you burned up the capital loss in year 1, you’ll have to pay additional tax in year 2.
There are rare situations where you may be better off using the capital loss in year 1. For example, suppose your capital loss is a long-term capital loss and your gain is a short-term capital gain, and suppose further that you have no intention of holding the mutual fund shares long enough to produce a long-term capital gain. You’re simply deciding whether to sell the shares now, in December of year 1, or wait until January of year 2. If you sell now, you’re assured that your capital loss will offset this short-term capital gain. But if you wait until January, you’ll carry over a long-term capital loss, and it will have to be used first against any long-term capital gains. As a result, if you have long-term capital gains in year 2, the carryover will offset those gains instead of the short-term gain from the mutual fund shares you sold in January.
Notice all the things that have to be true to get a benefit from the early sale strategy. The capital loss has to be long-term. The gain has to be short-term, and it would have to remain short-term (a definite plan to sell the shares before owning them for a year). And you have to have long-term gains from some other asset in year 2. You need the amazing coincidence of all those things, or some other very unusual circumstances, before you can benefit from the early sale strategy.
A Bad Idea
In nearly all cases, the strategy of using up a capital loss sooner than necessary is a bad one. It rarely produces tax savings, and often causes you to pay more tax than necessary in the long run. If you have excess capital losses, you should not be looking for ways to use them up. On the contrary, you should be preserving that capital loss carryover, because it is a potentially valuable benefit. When you use unnecessary capital gain transactions to consume excess capital losses, you aren’t using your capital loss to reduce your taxes. Instead, you’re using additional capital gains to reduce the benefit you can obtain from the carryover.