If you still like a stock or fund but want to realize losses, the tax code says you must wait 31 days after selling to buy it back or forfeit your write-off. But what if the security you sold rallies in those 31 days? Then you've missed some upside. You have two strategies for avoiding this: substitution and doubling up.
With substitution, you buy a stock or fund similar to the one you've sold and hold it for the 31 days, then sell it and buy back your original holding. So if you dump Intel shares, but want to stay invested in microchips, you could buy shares of rivals Advanced Micro Devices (AMD
) or STMicroelectronics (STM
You could also substitute with an exchange-traded fund (ETF) that's heavily invested in the stock. If, say, you've lost money on erstwhile biotech darling Amgen (AMGN
), you could sell it and buy the iShares Nasdaq Biotechnology Index Fund, which has 24% of its assets in Amgen. Replacing funds with ETFs also works, but be careful the overlap between the sold fund's and the ETF's portfolios doesn't exceed 70%, or the Internal Revenue Service may disallow the write-off.
Doubling up on your stake in a fallen security, then selling the shares with losses after 31 days is a good strategy if you're bullish about its prospects. "The sell and buy decisions depend very much on how important the stock is to your overall portfolio," says David Stein, chief investment officer of Seattle-based Parametric Portfolio Associates, which focuses on tax strategies. He keeps stock positions below 5% of portfolios. So doubling up on a stock that has fallen, say, 50% and now has a 2.5% weighting doesn't expose clients to more risk than they signed up for. But if you have a big position, you may want a substitute.
Timing your sales is crucial. If your stock has appreciated, it's usually better to sell after you've held it at least a year, because the gains are taxed at a 20% rate. Selling before a year yields short-term gains, which are taxed as income, usually at a much higher rate. As a result, short-term losses are more valuable than long-term ones, because they can offset short-term gains. So if you have a losing position, sell it before it turns a year old.
Generally, it's best to sell your highest-cost shares first, so you can garner the biggest loss. This is a style of selling called Highest-In-First-Out, or HIFO. But it sometimes makes sense to sell shares with a lower cost basis. If you own stock or fund shares with an average cost of $15, which you've held for two years, and shares at $14, which you've held for six months, it may be better to sell the $14 shares first because you can realize a short-term loss and apply it against a short-term gain.
To squeeze the largest deduction out of your sales, keep track of the time and cost per share of each purchase. That may require a software package such as Quicken 2003 or a broker such as Fidelity Investments, which tracks different tax lots for you. Before making the trade, notify your broker which lot of shares you're selling and ask for paper confirmation of the sale. As with any financial info the IRS may comb through one day, make sure your records are as thorough as possible. By Lewis Braham