When markets get crazy it can be comforting to find certainty, and for this we look to… taxes? Yep, that’s right, the most certain thing in our whole financial system.
Knowing that we will eventually have to pay taxes on every productive thing we do tells us that it is usually a worthwhile endeavor to give ourselves any tools possible to avoid this outcome. And right now, with capital markets taking a dip many investors may have the opportunity to do just that.
Many things go on to generate taxes in a taxable investment account, but the one we’re interested in right now is the realization of capital gains or losses. Most people have heard this term, but the details may be fuzzy.
A capital gain is something that is realized whenever you make money on an asset and then sell it to realize that gain. If you hold the asset for a year and then sell it you have a long term gain. If you sell it before a year you have a short term gain. Capital gains can also be paid out of some investments like mutual funds.
The same rules are apply to losses on assets. Losses, however, will not be paid out of your investments, but can help offset gains within the investment
The confusing part of these rules though is how these things combine at year end to determine your tax liability.
How this works is you net out each type of gain and loss first, then see what your overall net exposure is for the year.
So if someone had $3000 in short term losses and $5000 in short term gains they would have a net $2000 short term gain.
Then if they also had $6000 in long term losses and $1000 in long term gains they would have a $5000 long term loss.
Their long and short term results would then be netted to show a net $3,000 long term loss for the year.
So basically there are 3 outcomes for any given year:
- You net a loss (long or short term) which can be used to offset up to $3,000 in income and the remainder can be carried forward for future years.
- You net a long term gain to which capital gains rates will apply
- You net a short term gain which will be taxed as normal income
Now all that’s wonderful, but how do you get losses if they don’t pay out and only happen when you sell something? We’re not supposed to sell things in down markets right?
Generally, we try to avoid doing that, but that doesn’t mean that we can’t rebalance to reposition ourselves. Many times it can be possible to rebalance a portfolio to realize your losses, but not exit the market or dramatically change your level of risk.
This can be a great way to get a double benefit of making sure your holdings suit your risk tolerance and getting those helpful losses on the books for the next time the government comes to collect some of your earnings.