There will be times where you may want to realize a capital loss for tax purposes: this capital loss can be used to offset future capital gains.
With mutual funds, by exchanging funds, you can realize a capital loss for tax reasons without necessarily incurring a long term investment loss.
Here’s how it works:
- Assume you own a Vanguard S&P 500 Index fund. You bought it for $100,000 at the beginning of the year. The market went down, and it is now worth $70,000. You know in the long run the markets will recover, so you don’t want to sell it at a loss, but you would like to be able to use the loss for tax purposes.
- Instead of selling your fund, and going to cash, or a different type of investment, you sell it and buy a fund that owns the same underlying stocks; the Fidelity Spartan S&P 500 Index fund for example. Both funds own the same portfolio: all the stocks listed in the S&P 500 Index. Now, as the market recovers, your portfolio will recover.
- Since you switched to a different investment, that $30,000 loss will be considered a realized loss, and you will report it on your tax return.
- The loss can be used to offset other capital gains you may have. $3,000 of the loss can be deducted against ordinary income. You can then carryover any remaining loss to the next tax year.
This strategy works great with mutual funds, or exchange traded funds, as it is easy to find numerous funds that own the same underlying stocks. With this type of exchange you can capture the tax loss while staying invested in the correct investment allocation.
With individual stocks, this strategy does not work in the same way. Although you can sell your existing stock, and realize the loss, you cannot easily replace it with a similar stock that would be expected to perform the same.
When selling investments to realize a capital loss for tax purposes, make sure you are buying investments with different ticker symbols. If you sell and buy the same security within 30 days, the wash sale rule may apply, and your tax loss could be disallowed.
The wash sale rule does not apply if you sell and buy mutual funds with different ticker symbols, even if the two funds own the same underlying securities.
