December is a good time of year for taxpayers to take a look at the performance of their investments over the past year. During that time taxpayers might consider selling some assets, either to free up cash for future investments or living expenses, or to harvest capital gains in their account.
The basic harvest
Before a taxpayer can properly plan their capital gains harvesting, it is important to understand capital assets and how gains/losses are determined. A capital asset includes just about everything a taxpayer owns for personal use (not business) such as a home, stocks, bonds, cars, etc. When capital assets are sold, the difference between the proceeds received and the original cost basis of the asset is the resulting gain or loss. If the proceeds are more than the cost, the result is a gain, and vice versa a loss. Once the gain/loss is calculated, the next step is to determine if the gain/loss is long-term or short-term. If the asset had been owned by the taxpayer for 1 year or more when it is sold, then the gain/loss is long-term. Otherwise, the gain/loss is short-term.
Basic capital gains harvesting attempts to offset capital gains against capital losses. For example, let's say a taxpayer has $10,000 worth of investments in their account. $5,000 of the investments have an unrealized gain of $1,000, and the other $5,000 have an unrealized loss of $1,000. The taxpayer can sell all of the investments, generate $10,000 in cash, but have zero capital gains, because the $1,000 gain offsets the $1,000 loss.
Tax rates
Unfortunately, if the taxpayer's investment account has significant gains, 2013 might not be the best year to start liquidating large portions of their portfolios. As has been the case for several years, long-term capital gains are only taxed at 15%, but beginning in 2013, taxpayers with income in excess of $400,000 (single) or $450,000 (married) could be subject to a 20% capital gains tax rate. Of course this applies only to long-term capital gains; short-term capital gains are always taxed at the ordinary tax rate.
Reap what you sow
Taxpayers often ask themselves "if I sell assets at a gain and other assets at a loss, don't I lose money?" The answer is yes and no. Yes, the taxpayer loses money on the assets sold at a loss, because they spent more on the initial purchase than they received from the sale. At the same time, the answer is no because the taxpayer still receives cash from the sale. This cash can be used to make additional purchases and investments, without any tax consequences because the capital gains and losses offset each other.
Another aspect to consider is the capital loss carryover. Individual taxpayers are allowed a maximum of $3,000 in net capital losses be reported on their tax return. The good news is that the capital losses not used in that year can be carried forward to future years. Therefore, if a taxpayer has long-term capital gains of $1,000 and long-term capital losses of $5,000 (net capital loss of $4,000), the maximum net capital loss they can report on their tax return is $3,000, but the other $1,000 can be carried over to future years. This means that in the next year, $1,000 in capital gains could be taken without taking any corresponding losses, because the $1,000 could be used from the previous year.
December is a good time to review investment holdings and consider harvesting capital gains in order to generate cash with minimal tax consequences. At the same time, taxpayers should also consider if they have any capital loss carryovers on their Schedule D from the previous year.
Happy harvesting!