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GainsKeeper Suggests Year-End Tax Planning Strategies to Minimize 2004 Taxes Owed

By taking time now to plan, investors can better manage investment gains and losses come tax time, while avoiding the costly wash sales and short-term capital gain pitfalls

BOSTON, Dec. 1, 2004—What appears to be a lackluster year for investors could be worse for those who don’t carefully review their portfolios for possible tax saving strategies, according to Cameron Routh, head of partner relations for GainsKeeper^®. GainsKeeper, a part of Wolters Kluwer Corporate & Financial Services, is the leading automated tax lot accounting service for the investment community.

“Individuals need to make their own investment decisions based on their situation, but tax implications should be factored into the equation as they can help you hold onto more of what your investments earn,” Routh said.

Among the tax considerations and strategies that investors may want to brush up on as they review their portfolios toward the end of 2004:

Thanks to tax changes last year, most investors now have a maximum long-term capital gains rate of 15 percent, while those in the 10- and 15-percent tax brackets pay 5 percent for long-term gains. However, the long-term capital gains rates only apply to investments held for more than 12 months. Short-term gains (those from investments held less than a year) are taxed at the investor’s income tax rate, which can be as high as 35 percent.

Avoiding short-term gains can significantly reduce taxes. For example, an investor who purchased 100 shares of a security three years ago, and then again six months ago, each at a total cost of $2,000, would see a significant difference in their tax liability depending on which lot they sell. If the proceeds from selling 100 shares were $5,000, thereby creating a $3,000 capital gain, an investor in the 35-percent tax bracket would incur a $1,050 tax liability by selling the lot purchased six months ago ($3,000 x 35%). If they sold the lot purchased three years ago, the liability would be just $450 ($3,000 x 15%), a savings of $600.

This process of selecting specific lots to sell, referred to as “versus purchase” or “specific ID,” is an effective tool in managing a tax-efficient portfolio. However, in order to take advantage of this, the Internal Revenue Service (IRS) requires investors to notify their brokerage or fund company of the intention to sell a specific lot prior to placing the sell order.

Routh cautions that coming up with the gain or loss calculation is more complicated than simply taking the purchase price and assuming that is the correct cost basis to determine gain or loss at the time of sale.

“Every merger, split, or other corporate action changes a share’s cost basis, as does any wash sales that may have been generated during the course of trading the same security,” Routh said. “It’s important to track these changes to cost basis so you don’t overstate a gain, requiring you to pay more in taxes than necessary, or understate your gain, leaving you liable for back taxes, interest, and other penalties.”

When an investor has capital gains, harvesting losses can offset those gains and reduce taxes. For example, 100 shares of a stock purchased in January 2004 that has an adjusted cost basis—the original cost plus any adjustments—of $50 per share and is now trading at $20 per share has an unrealized loss of $3,000. Should the investor choose to sell, he would realize the $3,000 in short-term losses which then could offset the same amount of gains, thereby saving up to $1,050 in taxes ($3,000 x 35%). If net losses exceed net gains, the IRS allows up to $3,000 to be used to reduce ordinary income. Any amount beyond the $3,000 limit can be carried forward to write off against gains or ordinary income in future years.

A “wash sale” occurs when an investor sells shares of a security at a loss and repurchases a substantially identical security within 30 days. To further complicate this rule, the security could be repurchased 30 days before or after the sale for a loss, effectively creating a 61-day window. When a wash sale is triggered, your loss is deferred and the cost basis of the new lot is increased to reflect the deferred amount.

For example, you sold 100 shares in a security totaling $3,000 on November 15, 2004. Your cost basis was $4,000, so you have a loss of $1,000. Two weeks, later you purchased another 100 shares in the same security. This would create a wash sale, meaning that you can’t immediately realize the $1,000 loss from the original sale. Instead, you have to adjust the cost basis for the new shares to include the $1,000. If the original cost of the new shares was $2,200, the adjusted basis for those shares is now $3,200.

To avoid triggering a wash sale on a security sold for a loss, an investor can purchase a similar stock from the same sector, such as one chip maker for another or, in the case of mutual funds, a different fund with a similar investment objective—even if that security is from the same fund company.

However, Routh added, if you are buying and selling within the same security or fund, even if done in separate brokerage accounts, you would still be subject to the wash sale rule.

“Wash sales can cause a major problem for investors that are counting on losses to offset gains, as they won’t be able to immediately realize the loss and, therefore, will end up owing more in taxes than expected,” Routh said.

Doubling Down to Lower Taxes

Another tax-saving strategy—often used in highly volatile market conditions—is known as “double down.” For example, say you have a large unrealized loss in a security. You’d like to realize—or harvest—those losses for tax purposes; however, you also think the security is still a good investment and don’t want to be out of the market for fear of missing out on any appreciation. To harvest the losses, you could sell the shares and then wait 31 days to buy it back again, thereby avoiding the wash sale rule. You’d be able to realize the loss for tax purposes and still remain long in the security. Unfortunately, during those 30 days the value of the shares could rise and you’d miss the appreciation. With double down, rather than selling, you would first buy another 100 shares. Then after 30 days—but still within the same tax year—sell your first lot and realize the loss, therefore lowering your tax liability, while remaining continually invested in the holding.

According to Routh, these are just some of the strategies used by investors to manage tax liabilities. Of course, tax considerations are just part of a sound investment strategy and should never be the sole criteria for making investment decisions. However, by being vigilant about the tax implications of investments, investors can maximize the after-tax performance of their portfolios.

GainsKeeper, a part of Wolters Kluwer Corporate & Financial Services Division, provides automated tax-based financial tools and services to the investment community. GainsKeeper Institutional Services (GKIS) provides application service provider (ASP) solutions for financial institutions, enabling them to offer sophisticated tax lot accounting services to their customers without incurring the high cost of building, maintaining, and housing the systems and operations necessary to provide institutional-quality service. GKIS solutions ranging from back-office outsourcing to fully integrated Internet-based tools and services are utilized by the brokerage, mutual fund, and fund administration industries.