Tax Savings Techniques for Security Gains

Nobody can be very happy about the stock market’s performance in the last year or so. That said, the market’s recent rebound may actually have left you wondering whether it’s time to capitalize on some of those newly realized gains on stocks you purchased during the downturn. While taxes should not be the main consideration in this decision, they certainly need to be considered as they can make a significant impact on your investment return.

With that in mind, here are a couple tax smart strategies to consider as you analyze your investment opportunities and decide what to do about recent gains.

Should You Wait to Sell Until the Stock Qualifies for Long-term Capital Gains Treatment?

If the stock sale qualifies for long-term capital gain treatment, it will be taxed at a maximum tax rate of 15%. Otherwise it will be taxed at your ordinary income tax rates, which can be as high as 35%. Clearly, you’ll pay less taxes (and keep more of your gains) if the stock sale qualifies for long-term capital gain treatment. The amount of taxes you’ll save depends on your ordinary income tax bracket.

To qualify for the preferential long-term capital gain rates, you must hold the stock for more than 12 months. The holding period generally begins the day after you purchase the stock and runs through (and includes) the date you sell it. These rules must be followed exactly, because missing the required holding period by even one day prevents you from using the preferential rates.

The question then becomes: Are the tax savings that would be realized by holding the asset for the long-term period worth the investment risk that the asset’s value will fall during the same time period? If you think the value will fall significantly, liquidating quickly, regardless of tax consequences, may be the better option. Otherwise, the potential risk of holding an asset should be weighed against the tax benefit of qualifying for a reduced tax rate.

Comparing the risk of a price decline to the potential tax benefit of holding an investment for a certain time is not an exact science. However, the following should be considered:

1. Your expected ordinary income tax rate relative to the anticipated capital gains rate.

2. The amount of appreciation that will eventually be taxed.

3. How much longer the asset must be held to qualify for favorable capital gain rates.

4. Whether any existing capital losses could offset the gain (and the benefit of the lower rate).

Use “Specific ID Method” to Minimize Taxes

If you are considering selling less than your entire interest in a security that you purchased at various times for various prices, you have a couple options for identifying the particular shares sold—(1) the first-in, first-out (FIFO) method and (2) the specific ID method. FIFO is used if you do not (or cannot) specifically identify which shares of stock are sold, so the oldest securities are assumed to be sold first. Alternatively, you can use the specific ID method to select the particular shares you wish to sell. This is typically the preferred method as it allows you at least some level of control over the amount and character of the gain (or loss) realized on the sale, which can lead to tax savings opportunities.

For example, if you realized some capital losses earlier this year (or you have a capital loss carryover from last year), realizing a short-term (vs. long-term) gain may be advantageous. This can be accomplished by specifically identifying the newest shares of a particular security as sold. Then, the older shares can be sold (generating a long-term gain) later, when the gain will not be offset by capital losses.

Be careful, though, if your basis in the shares differs (and it usually does), the specific ID method affects the amount of the gain as well as the holding period. Sometimes, reducing the current taxable gain by selling the highest basis shares first is more beneficial than obtaining the lower long-term capital gain rate. Each case will depend on your specific facts, and will require comparative calculations.

The specific ID method requires that you adequately identify the specific stock to be sold. This can be accomplished by delivering the specific shares to be sold to the broker selling the stock. Alternatively, if the securities are held by your broker, IRS regulations say you must notify your broker regarding which shares you want to sell and identify them by reference to their purchase date and per-share price. The broker must then issue you a written confirmation of your instructions.

Unfortunately, discount and online brokers may be unwilling or unable to issue these confirmations. In this scenario, the Tax Court’s 1994 Concord Instruments Corp. decision seems to say you can give oral instructions regarding which shares to sell and still use the specific ID method even though no confirmation is forthcoming. However, you should carefully document your instructions by making notations on the written transaction statements received from your broker (and it is still better to follow the requirements under the IRS regulations when possible).