Turn Market Losses Into Tax Savings

So far this year, the stock market has shed over $8 trillion in value. Taxpayers know that when we make profits in the market, we have to share those gains with Uncle Sam. It's only logical, then, that the silver lining to the 2008 market meltdown must be huge tax savings. Imagine if all those losses showed up on tax returns next April. Investors would save hundreds of billions of dollars in taxes.

But that's not going to happen.

For one thing, a lot of those losses are inside IRAs and 401(k)s, so they're not deductible at all. Just as profits inside of IRAs aren't taxed, neither are losses deductible. It's all part of the same bargain. Just like in Vegas, what goes on in a tax shelter stays in the tax shelter. The IRS simply doesn't want to hear about it.

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Even in taxable accounts, plummeting prices don't automatically translate to tax losses. That only happens when you sell a security to transform your "paper loss" into a real loss. Sometimes, in fact, dumping a beaten and bloodied stock can even produce a taxable profit.

How's that?

Remember, your profit or loss isn't the difference between peak value and what you sell for; it's the difference between the price you paid and what you sell for.

Say you bought shares for $10 many years ago and they had soared to $50 when the market peaked in October 2007. If you sell tomorrow for $15 a share, you feel that you've suffered a 70% loss. But in the eyes of the IRS, you have a 50% gain.

Harvesting your losses

That's why it's so important to carefully review the "tax basis" of shares in your portfolio when planning year-end sales. Your basis is what you have invested in the stock or the mutual funds shares.

A key year-end strategy is called "loss harvesting." It involves selling stocks to realize losses. You can then use those losses to offset any taxable gains you have realized during the year. Losses offset gains dollar for dollar and up to $3,000 of excess loss can be used to wipe out the tax bill on other kinds of income, such as your salary or interest or rental income.

If losses exceed your profits by more than $3,000, the excess loss is carried over to the next year. You can use it then to offset any 2009 gains, plus up to $3,000 of other kinds of income. You can carry over losses year after year for as long as you live.

Be specific

If you want to realize a loss for tax purposes, be sure to tell your broker or mutual fund exactly which shares to sell to produce the result you're after. If you don't give specific orders, a rule called FIFO (first-in/first-out) kicks in with the assumption that you're selling the shares you have held the longest. If those shares have a lower tax basis than those you bought later, the sale will produce a smaller loss, or maybe even a taxable profit.

Again, an example helps. Let's say you bought 100 shares of a company for $10 in 2000, another 100 for $15 in 2004 and a third lot of 100 for $20 a share in 2006. And, assume the shares are trading for $5 a share now. If you simply direct your broker to sell 100 shares, it's assumed you're selling the shares purchased in 2000. Your tax basis of those shares is $1,000 (100 x $10) and you'd get $500, leaving you with a $500 loss.

But look what happens when you tell the broker to sell the lot purchased in 2006 for $20 a share. Your tax basis in that lot is $2,000. Subtracting the $500 you receive from the buyer leaves you with a $1,500 tax loss. The extra $1,000 deduction could save you $250 if you're in the 25% bracket.

Note this: You need a written confirmation that you ordered the sale of specific shares -- something like, sell shares from the lot purchased November 16, 2006. So ask your broker or mutual fund for a letter or an e-mail confirming your instructions. You'll need it, in case the IRS audits your return, to prove that you made the decision of which shares to sell before the deal, not when you were sitting down with your tax return.

Mutual fund twist

There is one twist when it comes to mutual funds. If you don't specifically identify which shares to sell, you're not automatically stuck with the FIFO method that applies to stocks. With funds, a there's a third choice: average basis. It allows you to find the average basis of all the shares you own in the fund, multiply that by the number of shares sold in the transaction you're reporting and use that amount as your tax basis.

In the example above involving three lots of 100 purchased at $10, $15 and $20, the average basis would be $15 a share. Most fund companies now keep track of average basis and report it to shareholders (but not the IRS) when they redeem shares.

Although using the average basis may be easier than specific identification, specifying exactly which shares you want to sell gives you the greatest control over your tax bill.