Last Chance to Soak up Capital Losses

Don't do it!

By Kaye A. Thomas
Posted December 27, 2007

It's better to preserve a capital loss carryover than to use it needlessly.

Every now and then, especially near the end of a year, we hear from someone who's planning to sell stock at a gain and repurchase the shares immediately afterward. They're looking to soak up a capital loss that will otherwise be unused for the current year because of the $3,000 capital loss limitation. Often they want to know if the wash sale rule, or any similar doctrine, will stand in the way of the tax result they're seeking. But the real problem here is that the strategy doesn't make sense in the first place. Using up the loss in the current year rarely provides any advantage, and often means a larger tax bill in later years.

The $3,000 limitation

The tax rules allow you to claim a deduction for capital losses up to the amount of your capital gains plus $3,000.

Example 1: If you have $30,000 of capital gains and $20,000 of capital losses, you can deduct the full amount of your losses. It doesn't matter that they're more than $3,000.

Example 2: If you have the reverse situation, $20,000 of capital gains and $30,000 of capital losses, you're allowed to deduct $23,000 of the capital losses (the amount of your capital gains plus $3,000). You have $7,000 of capital loss you aren't allowed to use this year.

The capital loss carryover

What happens to the $7,000 of capital loss you weren't allowed to use? It carries over to the next year. In essence you're treated as if you had a $7,000 capital loss on January 1. Some people have the mistaken impression that there's a special limit on using this loss. In reality, you're allowed to use it the same as an actual capital loss you have in the later year. In our example, if you have $4,000 or more of capital gain in the following year without any new capital loss, you can use the entire $7,000 in one year.

A capital loss carryover isn't a bad thing. It's a good thing, because it's something you can use to reduce your taxes in a later year.

Use it sooner?

Okay, maybe it's a benefit (some people say), but isn't it better to use it sooner? I don't want an unused tax benefit sitting around if I can use it now.

Here's the problem with that way of thinking. You aren't actually gaining a tax benefit if you make a sale only for the purpose of soaking up the capital loss. The sale and repurchase of the shares doesn't reduce the amount of tax you pay. You're using capital gain to wipe out a potentially valuable capital loss carryover, without any current savings.

You do gain one advantage when doing this: you end up with shares that have a higher tax basis. The problem is that this advantage is rarely as valuable as the capital loss carryover you wiped out. Let's walk through an example.

Example: Just before the end of the year you calculated that your capital losses would be $10,000 greater than your capital gains, so you have $7,000 more loss than you can use in the current year. You happen to hold some shares that cost $20,000 and are now worth $27,000. You sell them at the current price, producing a gain of $7,000, and the buy replacement shares for $27,000.

You might end up selling those shares later for, say, $35,000. In that case you would report gain of $8,000, because you repurchased the shares for $27,000. You've reduced the amount of gain on this sale by $7,000 — but this is not a net benefit. You end up in the same place as if you continued to hold the shares, carried over the $7,000 loss, and used that loss against the $15,000 gain when you sold the shares. Meanwhile you incurred brokerage fees and other transaction costs.

In that scenario the strategy of soaking up the loss leaves you no better off, but no worse off, than if you did nothing. There are other possibilities where the strategy actually costs you money. Suppose, for example, the following year you have $5,000 of capital gains and no capital losses. You've decided not to sell the shares you used to soak up the capital loss. In this situation you're stuck paying tax on the $5,000 gain. If you had done nothing, you would have a $7,000 capital loss carryover to wipe out that gain and provide an additional $2,000 deduction.

Bottom line: manufacturing a capital gain solely for the purpose of soaking up a capital loss puts you in a worse position than if you simply carry the loss to the following year. A capital loss carryover should be used when it produces a genuine benefit, not wasted on a needless transaction.