Monday, November 26, 2012

Harvesting Capital Losses to Boost Returns of Stocks and Mutual Funds

Most investors know that the return from stocks and funds can take the form of price appreciation and dividends. But there is a third, less well-known option: capital loss harvesting.

Capital loss harvesting consists of selling a stock or fund that is down in price, and immediately replacing it with a different security in the same group or sector.

For example, let’s say that we buy $5,000 of HP stock. It then drops in value until our stock is worth $3,000. Eventually, the stock returns to break even. Aside from any dividends, we have not made any money.

On the other hand, if we could have sold our HP stock when it was worth only $3,000, and immediately bought it back, we could have had a $2,000 capital loss that we could use to offset other income.

Unfortunately, the IRS disallows this through the wash rule. If you sell a stock for a loss, and use the capital loss for tax purposes, then you cannot buy back the stock for 30 days. During that time, the market may have started to come back, causing us to miss some appreciation.

There is a way around this. We could have sold HP, taken the $2,000 capital loss, and immediately bought back another company with a similar size and profile (for example, IBM). The stocks should both participate in any near-term market rallies.

Since up to $3,000 in capital losses can be used to offset regular income then, assuming the investor is in a 30% tax bracket, the $2,000 capital loss is worth $600 – which is a 12% return on our original $5,000 investment.

We can use a similar technique with mutual funds. For example, you can sell a fund that is down in price, and substitute another fund from the same category.

Praveen Puri has 20 years of trading and investment experience – including serving as a consultant to major insurance companies, banks, and the Chicago Board of Trade. He is the author of Stock Trading Riches, which details a mathematical stock trading method that isn’t exciting or “sexy”, but is extremely lucrative.

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