The following is information as to how you are taxed on the gains and losses from your investments.
First you must separate your long-term investments from your short-term ones. Long-term, for these purposes, means those which you held for more than a year. Those held for one year or less are short-term. At this point, a "netting" process is used. Short-term losses are netted against short term gains. The same is done for long-term gains and losses. The tax treatment depends on the results of these operations. The following four possibilities can arise:
- Long-term gain and short-term gain. If your long-term and short-term net results are both gains, the short term gains are taxed at ordinary income tax rates. The long-term gains are included in income but cannot be taxed at a rate higher than 28%. Thus, if you are in a tax bracket above 28%, your long-term capital gains are taxed at a favorable rate.
- Long-term loss and short-term loss. If your long-term and short-term net results are both losses, you can deduct up to only $3,000 of them against your other income. You must draw the $3,000 from the short-term losses first. Any losses in excess of $3,000 are carried forward for use in the following year's netting process. They retain their long- and short-term character. They continue to be carried forward indefinitely until used (except that unused losses expire at death).
- Long-term loss and short-term gain. If your long-term investments result in a net loss and your short-term investments result in a net gain, a second netting is undertaken, the loss against the gain. If the long-term loss is greater, you can deduct up to $3,000 and carry forward the rest, as discussed above. If the short-term gain is greater, it is taxed at your ordinary income tax rates.
- Long-term gain and short-term loss. If your long-term investments result in a net gain and your short-term investments result in a net loss, a second netting is undertaken, the loss against the gain, as in 3, above. If the short-term loss is greater, you can deduct up to $3,000 and carry forward the rest, as discussed above. If the long-term gain is greater, it is taxed at a maximum 28% rate.
Some planning suggestions. Since losses can only be used against gains (or up to $3,000 additionally), in many cases, matching up gains and losses can save you taxes. For example, suppose you have already realized $20,000 in capital gains in Year 1 and are holding investments in which you have lost $20,000. If you sell the loss items before the end of the year they will be used fully to "absorb" the gains. Alternatively, if you wait to sell them in Year 2, you will be fully taxed on your Year 1 gains and will only be able to deduct $3,000 of your losses (if you have no other gains in Year 2 against which to net them).
Another technique is to seek to "isolate" short term gains against long term losses. For example, say you have $10,000 in short-term gains in Year 1 and $10,000 in long-term losses as well. You're in the 36% tax bracket in all relevant years. Your other investments are long-term and have gone up $10,000 in value, but you haven't sold them yet. If you sell them in Year 1, they will be netted against the long-term losses and leave your short term gains to be taxed at 36%. Alternatively, if you can hold off and sell them in Year 2 (assuming no other Year 2 transactions), the losses will "absorb" the short term gains in Year 1. In Year 2, the long term gains will then be taxed at only 28%.
Alternative minimum tax concerns. Although capital gains themselves aren't a "preference item" under the alternative minimum tax tax (AMT) system, they can indirectly trigger an AMT problem. This would most likely occur when your capital gains for the year are substantial. By boosting your taxable income, and thus your AMT income, they may (together with your preferences and other required AMT adjustments) cause the AMT to apply. (Please let me know if you are interested in additional information on how the AMT works.) Once it applies, you may lose tax benefits from items such as your state and local income and property taxes, certain types of tax-exempt interest, and depreciation deductions.
If you are aware of this ahead of time you may be able to save these tax benefits through planning. For example, some state and local tax payments can be shifted to other years, and certain types of tax-exempt investments can be avoided. Therefore, please let me know if you anticipate substantial capital gains so I can determine if you are at risk for an AMT problem.