What Is Crystallization?
Crystallization is the selling of a security to trigger capital gains or losses. Once there is a capital gain or loss, investment tax applies to the proceeds.
Breaking Down Crystallization
When an investor buys a capital asset, an increase (or decrease) in the value of the security does not translate to a profit (or loss). The investor can only claim a profit (or loss) after he has sold the security. Selling the security at a profit is referred to as crystallizing a capital gain.
Consider an investor, Smith, who purchases 100 shares of Nvidia Corporation (Nasdaq: NVDA) on October 13, 2016, for $65.35. The stock has steadily increased since he bought it and as of September 18, 2017, was $187.55. Until Smith sells the stock, he cannot crystallize the gain from the increase or state that he made a profit. If he decides to sell the stock for $187.55, his capital gain will be ($187.55 - $65.35) x 100 shares = $12,220. In this instance, he has crystallized $12,220 capital gains.
Smith may not get to relish in his good fortune for long since capital gains are taxed. As of 2017, the capital gains tax on a short-term investment is equal to an investor’s ordinary income tax rate. Long-term capital gains tax rate, depending on what marginal tax bracket an investor falls into, lies between 0% and 20%. Assuming Smith’s annual income for 2017 is $120,000, this means he falls in the 28% marginal income tax bracket, and therefore, the capital gains tax on his NVDA profit will be 15%. At the end of the tax year, he will pay 15% x $12,220 = $1,833.
Capital losses may be used to offset some or all capital gains. If Smith held 700 shares of Transocean Ltd. (NYSE: RIG) which he bought for $15.80 per share a year ago, but now trading in the capital markets for $7.30 per share, he can crystallize the capital loss on the investment to offset the capital gains on NVDA in order to reduce the capital gains tax bill. If he sells RIG, he will crystallize losses of ($15.80 - $7.30) x 700 = $5,950. Instead of reporting a capital gain of $12,220, Smith can instead report a gain of $12,220 - $5,950 = $6,270. Since he has used his crystallized capital loss to offset his gain, his capital gains tax will be 15% x $6,270 = $940.50.
Crystallization can be used as a strategy in selling and buying stocks almost instantaneously to increase or decrease book value. An example of this occurs when an investor needs to take a capital loss for a particular stock but still believes the stock will rise. Thus, s/he would crystallize the paper loss by selling the stock and repurchasing it right away. In our example above, Smith sold his RIG shares for a capital loss to reduce his capital gains tax liability. If Smith believes that the stock still has the potential to increase in value, he can re-purchase it for his portfolio.
Crystallizing a tax loss is not a problem. What you do after crystallization, though, might be a problem. Most tax agencies have regulations (such as the wash-sale rule) to prevent taking a capital loss in some dubious fashion. In the US and Canada, for example, an investor cannot claim a tax loss if he buys back the shares within 30 days of crystallizing a loss from the same shares. Following the example above, Smith will have to buy back Transocean shares after 30 days has passed.
Capital losses that have been crystallized can be carried forward indefinitely. The capital loss can be used to offset realized gains and reduce ordinary income tax (up to $3,000 per year) in subsequent years. For example, an investor who crystallizes $20,000 capital loss can apply this to his crystallized $5,000 capital gain. Since she will still have $15,000 after reducing her capital gains tax to zero, she can use up to $3,000 to reduce her ordinary income tax as well. For example, if her annual income for the year is $85,000, she will only be taxed on $85,000 - $3,000 = $82,000. The remaining $12,000 in crystallized losses can be used in the following years in the same manner.