Using Recognized Tax Losses to Mitigate the Sting of the Current Year Stock Market Decline

The first six months of 2022 has not been kind to stock market investors. Stock market indices are down on average 12 to 18 percent from their 2021 high points.

Many stock market investors are not happy with the performance of their stock portfolios with all of their realized investment losses during the first half of 2022. But some realized investment losses may have a silver lining in the form of possible tax relief. At the midpoint of the year 2022, now is therefore a good time to revisit the Internal Revenue Code (IRC) rules related to recognized capital losses resulting from the sale of securities held in taxable accounts.

The information presented does not apply to tax-sheltered accounts such as IRAs, qualified retirement plans, and the Thrift Savings Plan (TSP).

Summary of the Tax Rules Affecting Capital Gains and Capital Losses

When an investor sells a security – a security includes stocks, bonds, open-ended funds, closed-end funds and exchange-traded funds – that he or she owns and sells the security for less than what the investor paid for the security, the result could be a recognized capital loss. The investor can then use the capital loss in order to offset capital gains that may have resulted when the investor sells a security and receives more than what the investor paid for the security.

Capital losses can offset capital gains “dollar for dollar” from a broad range of securities. This means, for example, that the sale of a bond mutual fund at a loss can offset taxable capital gains from the sale of a stock index fund, cryptocurrency or real estate.

If an investor does not incur enough capital gains to offset all of the investor’s recognized capital losses, then the investor can deduct up to $3,000 of capital losses per year against ordinary income.

Ordinary income includes salary/wage, interest, pension, and rental income. Any unused capital losses in a particular calendar year carry forward to future years indefinitely to offset capital gains in those years. The following example illustrates:

Example 1. Melanie bought 300 shares of Apple stock in spring 2020 for a total of $18,000 ($600 per share). Also in spring 2020, she paid $50,000 for bitcoin cryptocurrency. Both of Melanie’s holdings are held in taxable accounts.

At current (2022) prices, if Melanite were to sell all 600 shares of her Apple stock shares would receive net sale proceeds of $33,000 and therefore she would incur a recognized capital gain of $33,000 less $18,000, or $15,000. If Melanie at the same time sold her bitcoin cryptocurrency, her net proceeds would be $34,000 and therefore Melanie would incur a recognized capital loss of $34,000 less $50,000, or $16,000.

Because Melanie sold both holdings in the same year, her recognized bitcoin cryptocurrency capital loss of $16,000 can offset her recognized capital gain of $15,000 resulting from the sale of her Apple stock shares. She will therefore not owe any tax on the $15,000 capital gain.

The remaining $16,000 less $15,000 or $1,000 capital loss resulting from the sale of the bitcoin cryptocurrency can offset other of Melanie’s taxable capital gains, or if Melanie does not have any other taxable capital gains, the $1,000 remaining loss can be used to offset Melanie’s 2022 ordinary income such as interest, salary, IRA or pension income, or rental income.

Like other investing and tax strategies, there are some details and rules related to the sale of securities that investors should be aware of, including:

• “Wash-sale” rule on the sale of securities. In order to prevent investors from “taking advantage” of the system, the tax code postpones the use of capital losses if an investor sells a security at a capital loss and then almost immediately purchases a substantially identical security within 30 days before or after selling the security that resulted in a capital loss. The purpose behind the immediate purchase is to take advantage of the depressed security price. These sequential transactions are known as “wash sales.”

“Wash sales” apply to stocks, open-end and closed-end funds and exchange-traded funds, among others. If an investor wants to stay invested in the holdings they have sold resulting in a capital loss and immediately (in the same year) utilize the capital loss, the investor should purchase a similar but not identical holding.

For example, an investor who sells an S&P 500 stock index fund at a loss and then uses the net proceeds to immediately purchase a total stock market index fund would not be subject to the “wash sale” rules.

• “Wash sale” rule exception for cryptocurrency. Since cryptocurrency is not considered as a security by the Securities and Exchange Commission (SEC), cryptocurrency is not subject to the “wash-sale” rules under current law. Congress has considered changing cryptocurrency status to a security but has not yet taken any action. This means that bullish cryptocurrency investors can harvest capital losses on a cryptocurrency holding in order to offset current or future capital gains from securities and then immediately repurchase another cryptocurrency holding immediately at depressed prices.

• Be wise when deploying capital losses. It is advisable for investors to use their capital losses wisely with respect to federal income taxes and therefore potentially shelter each year up to $3,000 of ordinary income such as interest and wages. This is because ordinary income is for most individuals taxed at marginal (generally higher) federal income tax rates compared to long-term (securities owned for more than a year) capital gains (taxed at “preferential” rates of 0 percent, 15 percent or 20 percent).

Beyond that, the capital loss maximum value usually lies in using them to offset short-term capital gains which are taxable at ordinary income tax rates.

• Watch investment fees including surrender charges when selling securities. High transaction or advisory fees (for example, surrender charges) can quickly erode the value of selling securities resulting in capital losses. If is important that investors note what these fees are before they sell their securities.

• Consider life expectancy. Selling securities resulting in an accumulation of capital losses (what is sometimes called capital loss “harvesting”) is not a recommended investment strategy for investors who are likely to die with unused tax losses. This is because under current tax law, capital losses expire at the investor’s death and cannot be passed onto survivors.

Also, there also is no capital gains tax imposed on the appreciation of the value of securities when securities family members or other individuals inherit the securities at the investor’s death. Therefore, there is no need to shelter those appreciated capital gains.

Federal employees and retirees who may be interested at this time in selling some of their securities held in non-retirement brokerage accounts in order to utilize any 2022 realized losses are encouraged to first talk to their investment and tax advisors in order to make sure that this selling strategy is appropriate for them and, most importantly, will not adversely affect their long-term financial goals.