How bad investments can pay off

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No one wants to lose money on an investment. But when it comes to taxes, a loss could turn out to be a good thing.

If you’ve made money via capital gains, a loss on another asset sale could help reduce or possibly eliminate your tax liability.

If you have no capital gains to offset, a portion of your losses can be applied against your ordinary income.

And if you have substantial losses, they could pay off on tax returns for several years.

Determining your basis

The first step in making use of a stock sale loss is determining the asset’s “basis.” Your initial basis is what you originally paid for the asset. It’s then adjusted by accounting for other expenses incurred while you owned it.

Basis is crucial for tax purposes. It will directly affect the amount of gain or loss that you incur when you sell an asset. When you sell any capital asset, its gain or loss come from the difference between its selling price and its adjusted basis.

You start with the price you paid for the security, and then account for activity, such as reinvested dividends and capital gain distributions and stock splits. You even can, in most cases, take into account fees you paid to acquire or redeem fund shares.

The final figure is the adjusted basis, which will determine how much of a gain or loss you’ll realize when you sell.

‘Harvesting’ your losses

Most of us have no problem selling a stock that gives us a capital gain. However, it’s often more difficult to let go of one that has lost value.

Maybe you have an emotional attachment to the security; it’s the stock of a company where you, or your family, worked for many years. Perhaps you took a flyer on the stock and now don’t want to admit that you should have done better market homework.

But selling the asset and recording the loss can put a poor investment to better tax use.

Timing your sale

A key consideration is when to sell. Although this choice should be made primarily with regard to your overall investment strategy, the timing of your loss will determine exactly how tax valuable it is to you.

Just as capital gains are either short- or long-term, so are losses. If you sell a losing stock you’ve owned for a year or less, that constitutes a short-term loss. Stocks that you’ve owned for more than a year and then are sold at a loss are long-term losses.

The distinction is important because your capital gains and losses aren’t simply dumped into one investment bucket. You use your short-term losses to first offset short-term gains; the same process is used for long-term investments.

When you use your capital loss amounts to reduce the corresponding capital gains, any leftover capital losses can next be subtracted from the other type of capital gain. For example, you have $3,000 in short-term losses, but only $1,000 worth of short-term gains. You can apply the extra $2,000 short-term loss to any long-term gain you have.

If you have any capital losses left over after using them against gains, up to $3,000 of that excess loss amount can be deducted against your ordinary income, your salary, and other earnings. If you have more than $3,000 in excess losses, you can carry that amount forward to apply it to gains or ordinary income in future tax years. Just make sure you hang onto your tax and investment records.

You also can use your capital losses against ordinary income in tax years when you have no capital gains to offset. In these cases, the $3,000 per year limit still applies. But you can take as many years as necessary to use up the excess loss amounts.

Zero percent considerations

If you’re eligible for the zero percent rate on capital gains, you might want to examine your loss-taking strategy.

Through 2010, taxpayers in the 10 percent and 15 percent tax brackets don’t owe any taxes on long-term capital gains. So selling losing long-term stocks during this time means that you don’t get the maximum benefit of your losses.

True, you still can use up to $3,000 of the losses to reduce your ordinary income amount, but it might be worth postponing the taking of those losses until a future tax year when they could be used to more fully offset any taxable capital gains.

Of course, the tax treatment of your asset sales is just one factor to consider. If your investment strategy calls for you to sell a particular stock, regardless of its relative tax value, then you should do so. But you also should talk with your tax and investment advisers as to how some investment moves might be maximized from a tax standpoint.

Losses that aren’t deductible

Finally, keep in mind that not all asset sale losses provide tax advantages. Losses incurred upon the sale of personal-use property, such as your home or car, are not deductible.

This is an excerpt from Kay Bell’s new book, “The Truth About Paying Fewer Taxes“, reprinted with permission from FT Press.