Beware Capital Loss Whipsaw

Current market creates perfect storm

By Kaye A. Thomas
Posted February 7, 2008

Big losses after big gains are a formula for disaster.

A whipsaw is a situation where you lose on both ends. When it comes to taxation of investments, most disasters relate in one way or another to a capital loss whipsaw. This is a situation where you have to report income or gain from a profit that later gets reversed into a capital loss you can't deduct. The stock market's recent performance creates conditions where many investors may face this situation in 2008.

Lose, then gain: not so bad

If you actively trade your investment account you're likely to perform well during some periods and poorly during others: that's just the nature of the game. You don't have a tax problem if you suffer losses in one year and recoup them the following year. Any portion of the loss that remains unused in the bad year carries over to the next year when you can use it against your gains. You'd prefer not to have the losses in the first place, but at least in this situation your tax results will reflect your trading results. Overall you have zero profit, and you've been taxed on zero profit.

Gain, then lose: tax disaster

Turn that situation around and you have a real problem. Suppose your trading produced gains of $100,000 during 2007 but you lost the same amount in 2008. You have to pay tax on the gain for 2007, even if the entire profit has disappeared by the time you file your tax return. What's worse, the $3,000 annual capital loss limitation will prevent you from claiming more than a small fraction of the 2008 loss. You have a capital loss carryover to 2009, but that may be small consolation. Overall you have zero profit for the two years of trading, just as in the previous example, but in this case you're out of pocket for a big tax bill in 2007, with no significant offset in 2008.

Unused capital losses carry forward to the next year but you aren't allowed to carry them back to an earlier year.

Dangerous times

Recent market performance creates the conditions where many investors may experience a painful capital loss whipsaw. Despite some falloff near the end of 2007, the overall trend for that year was up, making it easier to produce gains. A steep decline in the early weeks of 2008 makes it likely that many of the people who enjoyed gains last year are now suffering losses.

If you're in this situation — strong success last year coupled with losses in 2008 — now is the time to get a handle on the situation. Find out how much tax you'll owe for 2007 and make sure you've set aside funds to cover that liability. A big enough meltdown in your trading account could leave you without enough money to pay the tax from the previous year. Even without a loss of that magnitude you'll want to evaluate your strategy in light of the possibility you'll be paying tax on profits that no longer exist.