Analyzing Your Client's Financial Profile - Netting Capital Gains and Losses and Wash Sales

Netting Capital Gains and Losses
If an investor makes a number of trades in a particular year, the end result could be a mix of long-term and short-term capital gains and capital losses. The IRS is specific as to how these gains and losses are to be netted against each other. Here are the steps:

  • Net short-term gains against short-term losses.
     
  • Net long-term gains against long-term losses.
     
  • If both holding periods result in gains (or both in losses), they are reported separately on Schedule D.
     
  • If one holding period results in a gain and the other in a loss, they are then netted against each other.
     
  • If capital losses exceed capital gains, up to $3,000 can be deducted against ordinary income in any one year.
     
  • Unused capital losses can be carried forward indefinitely to future years - each year, unused capital losses will first be netted against the current year's capital gains, followed by the $3,000 deduction against ordinary income.

Wash Sales
If you own a stock that has gone down in value, but you believe it will rise significantly in the future, it could be tempting to sell the stock and enjoy the resulting capital loss and then buy it back so you can enjoy the future capital gain. But the IRS does not permit you to take the loss if you buy the same (or similar) security back within 30 days of the sale. This is known as awash sale.

There are several ways to avoid the wash sale rule and still take advantage of the underlying strategy:

  • Wait more than 30 days to buy back the security
  • Buy a security with similar characteristics (e.g. sell shares of ABC growth mutual fund and buy shares of XYZ growth mutual fund)

The wash rule applies to transactions before and after the sell date. For example, you cannot buy additional shares of the security on October 1, sell the original shares on October 20 and then buy more shares of the same security on November 10. In essence, the wash sale rule covers a period of 61 days: the sell date plus 30 days before and 30 days after that date.

Look Out!
Don't be confused by the prohibition against buying back the "same (or similar) security" and the strategy of "buying a security with similar characteristics." In the first instance, "similar security" refers to securities that are convertible to the sold security, (such as call options, rights, warrants, or convertible bonds), which can result in owning the security at a later date.

The article Selling Losing Securities For A Tax Advantage contains valuable information on how to perform tax-loss harvesting to help reduce taxes on portfolio gains.

Exam Tips and Tricks
Consider these sample exam questions:

  1. Your client bought 100 shares of ABC stock on June 30. What is the first day of the following year the stocks could be sold for a capital gain?
    1. June 1
    2. July 1
    3. July 2
    4. June 30

The correct answer is "c", since the holding period begins July 1 (the day after the purchase). Long-term capital gains are only permitted if the holding period is greater than one year, so the correct answer is July 2.

  1. Your client has a net short-term gain of $3,000 and a net long-term loss of $8,000. Which of the following statements are true?
    1. The short-term gain is fully taxable
    2. $3,000 of capital loss is deductible against earned income
    3. There is a long-term loss carried forward of $2,000
    4. There is no loss carried forward
    1. I & III
    2. I & IV
    3. II & III
    4. I, II, & III

The correct answer is "c." The gain and the loss are netted and result in a $5,000 long-term loss. $3,000 of that can be used in the current year as a deduction against earned income, and there will be a carry forward of $2,000.

Corporate and Trust Income Tax
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