Yes, Virginia – the tax code can be our friend…

Hearsay you say – How could the tax code be anyone’s friend!  Hear me out. We all know that the main point of the tax code is to part the little guy from his/her/their hard-earned & saved cash but hidden in amongst the reeds are a few little nuggets that not only the Big Daddys of the world can use (Cat on a Hot Tin Roof reference there – fabulous movie for your holiday viewing).  Mind you, all of these comments pertain to your non-IRA accounts. Inside your IRA/Roth/401(k)/403(b) accounts the only tax code that really applies is when you take the money out of the account. Outside of those accounts, we have a lot more flexibility. (Disclosure – you really ought to talk with a tax preparer – there, that will make Compliance happy this week…)

One of the most useful of the code’s hidden gems is the capital gains loss. Yes, I’m aware that every investment guru since the beginning of investment time has preached “buy low and sell high” which is, in and of itself a solid strategy. However, when the markets tumble, it can make sense to sell in the red. In its purest sense, a capital gain is when a stock is purchased at one price and sold at a higher price. That difference is your capital gain and it has its own special tax code which is different from your income tax code. Essentially, the IRS is saying, you never got taxed on the difference between the buy price and the sell price so we’re going to do that now, thank you very much. If you hold mutual funds, all of that buying low and selling high that the fund manager does during the year is aggregated into one amount and passed on to you, the shareholder, whether you want it or not from a tax standpoint.

A capital loss is when a stock is purchased at one price and sold at a lower price (in the red, as it were). Those losses can be used to offset any gains you might have taken during the year or the gains you might receive from the mutual fund manager. Ironically, those fund managers only pass on the capital gains to the shareholders, parking capital losses for use against the following year (or years) gains. This is why the year after a market enters a recession you often don’t see any capital gains on your taxes (remember 2010…). Those managers banked the losses (and there were some hefty ones) to use against the gains as the markets rebounded. Further, there’s a nifty little feature that lets us take up to $3,000 right off your taxable income for the year if you can’t use up all of the losses against the gains. And, as if icing on the cake, if you have more than $3,000 of excess losses, you can carry that overage to following years to absorb capital gains in those years just like those fancy, usually overpaid, fund managers do (OK, they personally don’t get the losses but you get the insult…).

Yes, I can hear you all saying – But wait – why are we selling when you told us “we’re building 20-year portfolios” and you would be absolutely correct. For most people and most situations we ARE building long-term portfolios but that doesn’t mean we should look a gift horse in the mouth. We might be totally in love with a fund but if it is going to give us a tax gift of carry forward losses then I say, take it, thank that fund politely for 31 days and repurchase that same fund that we promise to love and cherish until it tanks again and we can take more losses for our tax bank.  Why 31 days you might ask? That’s the length of time the tax man says you have to stay out of a position for the losses to be valid. Repurchase sooner and you don’t get to use the loss on your taxes. 31 days is a small price to pay for potentially lowering your income tax bill.

So, as the labor market softens, spending slows, our illustrious leaders let the government teeter on a shutdown (again), and the markets start to react to the absurdity of the situation, the color red on your balance sheet could be your friend so don’t fear the losses (I was going to say “Don’t fear the Reaper” for you Blue Öyster Cult fans out there then I thought that might be just a tad too on the nose for the current situation – you choose..). With those losses, we can mimic Warren Buffett for a wee second and live like Big Daddy and his brethren.

With that, enjoy your Thanksgiving.