by Bob Rywick
The following rules apply to determine how long-term capital losses are used by individuals (and other non-corporate taxpayers, such as estates and trusts):
1. Long-term capital losses on the sale of collectibles are used:
● To offset 28 percent rate gain (i.e., other collectibles gain and Section 1202 gain on the sale of certain small business stock); then,
● To offset 25 percent rate gain (un-recaptured Section 1250 gain, i.e., gain attributable to straight-line depreciation taken on real property); then,
● To offset 20 percent rate gain (i.e., adjusted net capital gain taken into account before May 6, 2003); then,
● To offset 15 percent rate gain (i.e., adjusted net capital gain (but not qualified dividends) taken into account after May 5, 2003); then,
● To offset net short-term capital gains; and finally,
● To offset ordinary income to the extent of $3,000 ($1,500 for married filing separately).
2. Long-term capital losses taken into account before May 6, 2003 (other than collectibles losses) are first applied to offset long-term capital gains (other than 28 percent rate gain and 25 percent rate gain) taken into account before May 6, 2003. Such losses are then taken into account:
● To offset long-term capital gains (other than 28 percent rate gain and 25 percent rate gain) taken into account after May 5, 2003; then,
● To offset 28 percent rate gain; then,
● To offset 25 percent rate gain; then,
● To offset short-term capital losses; and then,
● To offset ordinary income to the extent of $3,000 ($1,500 for married filing separately).
3. Long-term capital losses taken into account after May 5, 2003 (other than collectibles losses) are first applied to offset long-term capital gains (other than 28 percent rate gain and 25 percent rate gain) taken into account after May 5, 2003.
Such losses are then taken into account to offset long-term capital gains (other than 28 percent rate gain and 25 percent rate gain) taken into account before May 6, 2003, and then other items in the same order as in No. 2, above.
4. Long-term capital losses carried over from a prior tax year (regardless of the source of the losses) are used to offset 28 percent rate gain first, then 25 percent rate gain, then 20 percent rate gain (adjusted net capital gain taken into account before May 6, 2003), then 15 percent rate gain (adjusted net capital gain taken into account after May 5, 2003), then net short-term capital gain, and finally ordinary income to the extent of $3,000 ($1,500 for a married taxpayer filing separately).
In 2003 and 2004, individuals (and other non-corporate taxpayers) are subject to tax at a rate as high as 35 percent on short-term gains and ordinary income. On the other hand, long-term gains (other than collectibles gain and un-recaptured Section 1250 gain) are taxed at a maximum rate of 15 percent if taken into account after May 5, 2003, and a maximum rate of 20 percent if taken into account before May 6, 2003.
However, to the extent that the gain would otherwise be taxed at a rate below 25 percent if it were ordinary income, the maximum rate would be 5 percent on gains taken into account after May 5, 2003, and 10 percent on gains taken into account before May 6, 2003 (but only 8 percent on gains taken into account before May 6, 2003, if the property had been held over five years).
To the extent possible, a taxpayer should try to avoid having long-term capital losses offset long-term capital gains, since those losses will be more valuable if they are used to offset short-term capital gains or ordinary income. To do this requires making sure that the long-term capital losses are not taken in the same year as the long-term capital gains.
However, this is not just a tax issue. As is the case with most planning involving capital gains and losses, investment factors need to be considered. A taxpayer won’t want to defer recognizing gain until the following year if there’s too much risk that the value of the property will decline before it can be sold. Similarly, a taxpayer won’t want to risk increasing the loss on property that he expects will continue to decline in value by deferring the sale of that property until the following year.
To the extent that taking long-term capital losses in a different year than long-term capital gains is consistent with good investment planning, the taxpayer should take steps to prevent those losses from offsetting those gains.
Example 1: Your client, a single woman in the 35 percent tax bracket, recognized short-term capital gains of $100,000 in early 2003. So far, she has not had any other capital gains or losses in 2003. She owns some corporate bonds with a basis to her of $400,000 and a value of $500,000 (due to a substantial decline in interest rates from when she first bought them). She doesn’t expect much movement in the price of the bonds over the next three or four months but would like to sell them and invest the proceeds in tax-exempt bonds.
Your client also owns some stock in Errata Corp. that she has held for more than one year. The stock has a value of $425,000 and a basis of $500,000. She expects the value of the Errata stock to either remain about the same or decline even more. Therefore, she would like to sell the stock as soon as possible.
Assume that before the end of 2003, your client sells the Errata stock at a loss of $75,000, and the corporate bonds at a gain of $100,000. The loss on the Errata stock will offset $75,000 of the gain on the bonds. This would leave her with a net capital gain of $25,000 taxed at a rate of 15 percent.
Her total tax on long-term capital gains would be $3,750 (15 percent of $25,000, since this gain would be taken into account after May 5, 2003). She will also have to pay a tax of $35,000 on her short-term capital gain of $100,000 (35 percent of $100,000).
On the other hand, if your client delays the sale of the bonds until 2004, she can use the $75,000 long-term capital loss on the sale of the Errata stock to offset the $75,000 of the short-term capital gain she recognized early in the year.
This will leave her paying a tax of $8,750 on the balance of her short-term capital gain in 2003 (35 percent of $25,000). If she sells the corporate bonds at a long-term capital gain of $100,000 in 2004, she will pay a tax of $15,000 on that gain (15 percent of $100,000) assuming she has no losses in 2004 to offset that gain. Her total taxes from the sales in 2003 and 2004 will be $23,750 ($8,750 in 2003 and $15,000 in 2004). This is $15,000 less than the total taxes of $38,750 ($35,000 on net short-term capital gains of $100,000 and $3,750 on net long-term capital gains of $25,000) that she would have to pay if all the sales took place in 2003.
Even if it’s not possible to use long-term capital losses to offset short-term capital gains or ordinary income, try to structure sales so that long-term capital losses will offset long-term capital gains that are taxed at the highest rate.
For example, try to have long-term capital losses on sales of property other than collectibles that are taken into account after May 5, 2003, offset 28 percent rate gain, 25 percent rate gain, or 20 percent rate gain, instead of having them offset 15 percent rate gain. This would require deferring, where it makes good investment sense, recognition of post-May 5, 2003, long-term capital gain (other than 28 percent rate gain or 25 percent rate gain) until 2004.
Example 2: In 2003, but before May 6, 2003, your client recognized long-term capital gains of $200,000 on the sale of stock. On July 5, 2003, he recognized a long-term capital loss of $150,000 on the sale of stock in another company. He also has stock in a bank on which he would recognize a long-term capital gain of about $100,000 if he sells it now. He believes that it’s more likely than not that his stock in the bank will increase somewhat in value if he delays selling the stock until early in 2004. He has no other capital gains or losses in 2003.
If your client sells the stock in the bank at a gain of $100,000 in 2003, that gain will be offset entirely by $100,000 of his post-May 5, 2003, long-term capital loss of $150,000. The $50,000 balance of the loss will offset $50,000 of his-pre-May 6, 2003, long-term capital gain of $200,000. He will pay a tax of $30,000 on the balance of his pre-May 6, 2003, capital gain (20 percent of $150,000).
On the other hand, if your client defers selling the bank stock until 2004, the post-May 5, 2003, long-term capital loss of $150,000 will offset all but $50,000 of his pre-May 6, 2003, long-term capital gain. He will pay taxes of $10,000 (20 percent of $50,000) on that balance.
If he sells the bank stock at a gain of $100,000 in 2004, he will pay taxes of $15,000 on that gain (15 percent of $100,000). The total taxes for 2003 and 2004 will be $25,000 ($10,000 in 2003 and $15,000 in 2004) instead of the total of $30,000 that will be paid in 2003 if the bank stock is sold in 2003.
Example 3: On May 1, 2003, your client sold some stock for which she had a long-term capital loss of $200,000. On June 5, 2003, she sold her stamp collection (a collectible) for which she had a long-term capital gain of $200,000. If she has no other long-term capital gains and losses in 2003, the loss on the sale of the stock will completely offset the gain on the sale of the stamp collection, so she will have no taxable long-term capital gain in 2003.
On the other hand, if she sells some stock in late 2003 for which she has a long-term capital gain of $200,000, the loss on the May 1, 2003, sale of stock will offset the gain on the post-May 5, 2003, sale of stock, and not the collectibles gain. She will have to pay a tax of $56,000 on her collectibles gain (28 percent of $200,000). If she defers the post-May 5, 2003, sale of stock until 2004, she will pay a tax of only $30,000 on that sale (15 percent of $200,000 — assuming that the stock is still sold at a gain of $200,000).
Therefore, her total taxes for 2003 and 2004 on long-term capital gains will be only $30,000 instead of the $56,000 that she would have had to pay if the post-May 5, 2003, sale of stock took place in 2003 instead of 2004.
