Turning
Fund Losses Into Tax Savings
By Richard Moroney, editor
Dow Theory Forecasts
For
the first time since 1941, stock investors face the prospect
of three consecutive down years. For fund investors, one silver
lining is that Internal Revenue Service wash-sale rules allow
you to record a taxable loss and upgrade to a better fund while
keeping your asset mix intact.
A wash sale occurs
when you sell a stock or fund at a loss and buy it back within
30 days. You cannot book a loss for tax purposes in a
wash sale. However, you can book a loss if you sell your shares
and wait 31 days before investing in the same security again.
But that means you have to sit on the sidelines for a month an
eternity if markets are rebounding.
IRS rules allow fund
investors to dump losers and immediately use sale proceeds to
purchase shares in a similar but not "substantially identical"
fund and still use the losses for tax purposes. So long as you
do not buy the exact same fund or another class of the same fund,
you are probably entitled to the tax break. Moreover, your portfolio
mix has not changed. Not a bad deal.
For example, say you
bought Fidelity Magellan at the start of the year and want to
sell, but don't want to miss a rally in the large-cap growth
stocks that dominate the fund's portfolio. Simply sell Magellan
and buy another large-cap growth fund on the same day.
Be aware of two potential
pitfalls. First, if you plan to switch to another fund, make
sure the replacement is not poised to pay a capital-gains distribution.
While few funds will be distributing big gains this year, it
pays to check. Many fund companies provide in November their
estimates of distributions slated for December, the most common
month for payouts.
Second, to qualify
for the complete taxable loss, there should be no reinvestment
of dividends or capital gains in the 30 days leading up to a
sale, nor should there be any reinvestments within 30 days after
the sale date (if you are selling just a portion of your holdings).
If this rule is violated, your taxable loss will be disallowed
by the amount of your reinvestment.
Selling at a loss can
lighten your tax burden. Investors can use losses to offset all
capital gains recorded in a year. After that, any excess may
be deducted from ordinary income, up to a maximum of $3,000.
For example, if you bought $25,000 worth of Fidelity Magellan
at the start of the year and dumped it now, your loss would be
roughly $5,400. Assuming you had no capital gains during the
year, $3,000 of the loss could be deducted on your 2002 tax return,
with the remainder carried forward. There is no limit on how
long you can carry capital losses.
As with most tax matters,
it is better to be safe than sorry. So check with your tax preparer
about wash sales and deducting capital losses. Or read IRS publication
550, Investment Income and Expenses (Including Capital Gains
and Losses), available at www.irs.ustreas.gov.
Editor's Note: Richard
Moroney is editor of Dow Theory Forecasts, 7412 Calumet Ave.,
Hammond, IN 46324. 1 year, 52 issues, $259. Visit the web site
at www.dowtheory.com.
