The vast majority of these articles will discuss the favorable treatment of long-term capital gains rate versus short-term tax rates. The ones that give you advice will probably say something like, “If you want to keep your tax bill low, it’s a good idea to hold your investments in your taxable accounts for at least a year to take advantage of long-term gains.”
I searched through the top 30 articles (or the first 3 pages of Google). In the results, I found virtually the same article written 29 times by Rocket Mortgage, Turbo Tax, Forbes, etc.
The one exception was the IRS website. Their page contains tax code references & IRS rules with more detail about tax treatment of short term gains. At least more detail than the folks trying to sell you a mortgage or get your tax return filing business.
Of course, when I see such unanimous advice, I start thinking,
“Wouldn’t there be a situation where I would want to trigger short term capital gains?”
Triggering capital gains
The obvious answer would be something like the 740% runup of Tesla stock in 2020. After all, anyone could make a strong argument for cashing in on their $10,000 after it turned to $84,000 in less than a year.
Even if you paid 50% in taxes (possible in some states when you factor in both federal and state income taxes at the top tax bracket), you’d still have quadrupled your money in a year’s time.
And seeing the decline of the stock market in 2022, some investors might be happy taking that money off the table, even if they had a taxable gain.
Certainly, you could argue that taking your money off the table makes sense. Even if it means paying taxes on short-term gains.
But there’s another answer out there, and I haven’t seen it online. And that’s when you have capital loss carryovers. The rest of this article will talk about that. But first, we’ll need to discuss a couple of things:
- How short term gains & losses work, vs how long term gains & losses work
- How capital losses might be disallowed (wash sale rules)
- How netting gains & losses works
- How capital loss carryover works
Short term gains & losses versus long term gains & losses
According to the Internal Revenue Code, the difference between short term and long term (for capital gains/losses purposes) is this:
Short term: You held the asset for one year or less before selling it
Long term: You held the asset for over one year (meaning 1 year plus 1 day) before selling it.
That’s it. Everything else is derived from that.
The difference between gains and losses is pretty straightforward. However, if you sell four or more different securities, it is possible to have the following:
- At least one sale at a short term capital gain
- At least one sale at a short term capital loss
- At least one sale at a long term capital gain
- At least one sale at a long term capital loss
But there’s only one line for capital gains & losses on the IRS Form 1040 (Line 7). So, that’s where netting comes in. Schedule D of your federal income tax return contains netting for capital gains taxes.
A quick reminder—when tax loss harvesting (selling securities at a loss with the intention of using those losses to offset taxable income), be mindful of the wash sale rule. Before we get into netting gains and losses, let’s quickly discuss the wash sale rule.
What is the wash sale rule?
In layman’s terms, the wash-sale rule prohibits selling an investment at a loss for tax purposes, then purchasing either the same asset or a substantially identical asset within 30 days. The 30 day limit applies to transactions before or after the sale.
However, the wash sale rule only applies to tax-loss harvesting. It does not apply to tax-gain harvesting.
How netting capital gains and losses works
A cursory look at Schedule D will give you a basic understanding of how netting capital gains and losses works.
Netting short term capital gains and losses
Part I records short-term capital gains and losses. Keep in mind, the numbers are the totals for all transactions recorded on Form 1099-B.
There are also provisions for short-term gains from a variety of sources, reported in different forms, as well as losses carried over from previous years. Line 7 contains the total sum, known as net short-term capital gain.
Netting long term capital gains and losses
Part II is virtually the same, but for long term capital gains and losses. Line 15 contains the total sum of this calculation, known as net long-term capital gain (or loss).
There is one distinct difference between Part I and Part II: capital gains distributions. Long term capital gains distributions are distributions of long term capital gains from holdings within your mutual funds or exchange-traded funds.
At the end of each year, the mutual fund’s investment manager calculates the capital gains from sales of securities within these funds and pass on the gains (and tax liability) to the owners. Short term capital gains are also distributed, but not captured on Schedule D because they’re counted as ordinary income.
Netting short term and long term gains and losses
This happens on Line 16. One of three things will happen:
- Line 16 is a gain. If this happens, then you follow the instructions, which will help you calculate exactly how much income, and how much tax you’ll end up paying on that income (depending on which tax rates apply).
- Line 16 is zero. Then you enter zero on your 1040, and complete the Qualified Dividends worksheet if you have qualified dividends.
- Line 16 is a loss. You’ll enter the smaller of:
- $3,000, or
- Whatever is on line 16
What happens to the difference? Nothing, in the current year’s tax return.
However, in the following year, you’ll be required (or you should, since it’s to your benefit) to fill out a capital loss carryover worksheet.
This isn’t an official part of your tax return, but it does help you bring the information from your previous year’s tax return to put into either line 6 (for short-term capital loss carryover) or line 14 (long-term capital loss carryover).
What to do with your capital loss carryover?
There are basically 3 things that you can do:
You get to deduct $3,000 per year from your ordinary income for as long as you continue to have capital losses to carry over each year. The downside is that if you have a big loss, it might take a while.
Offset long-term capital gains
This happens as a part of netting (long term gains are offset by long term losses). But why?
Your capital gains are already taxed at a preferential tax rate (at the time of this writing, anyway). So there is some benefit, but it’s not the biggest bang for your buck.
Offset short-term capital gains
This is where you get the most tax benefit for your money. After all, your short-term gains are taxed at ordinary income rates. So your marginal tax rate will always be higher here than at the long-term capital gains tax rate.
So when you offset those gains with carried-over losses (especially long-term losses), then you’re in a position for real tax savings.
Even if you’re offsetting them with losses, why would you want to trigger short term capital gains?
Good question. And while I don’t like to let the tax tail wag the dog, here are a couple of situations where this might be a good recommendation:
Rebalancing in a portfolio where you have mostly (or all) capital gains.
This happens a lot of times with buy and holds investors. Perhaps you sold a stinker of investment last year (triggering a loss), but didn’t need to rebalance much of anything else.
As the stock market changes, you might find that rebalancing is in order to maintain your asset allocation. Use that loss to offset the sale of something else so that you can keep a balanced portfolio.
You need cash.
Investments are there to earn investors money. Sometimes, you need to sell some (or all) of investment simply because you need the cash.
Taking money off the table.
Maybe you don’t need the cash, but your original investment isn’t looking as good as it did when you first bought. Perhaps you want to get out of those individual stocks before they tank.
That Tesla stock runup from 2020? It’s much easier to take that money off the table when you don’t have to think about the tax bill, and you’ve got some capital losses to offset the gains.
Resetting cost basis
If you’re in a lower tax bracket, but expect to move to a higher tax bracket in future years, you might consider this tax harvesting opportunity to reset your cost basis. If you sell and harvest capital gains today, you can immediately buy back that security.
Then, in later years, if you sell that investment, your future tax bill will be lower because:
- You have a higher basis in your investment
- As a result, you will have lower realized investment gains
Every once in a while, there’s a situation that arises where conventional wisdom isn’t the only way to go. And while purposely generating capital losses isn’t always a great strategy, it happens.