Tax Avoidance: Mixing gains and losses in the same tax year?

Question

I am currently looking at liquidating some of my investments and trying to decide which ones to sell, to cover some cash expenditures I will have. For the matter of this question, let's say I need $10,000.

I have already decided that I will be selling some stock lots worth $5,000 that incurred capital gains of $3000. But I will need to sell additional stock lots to meet my cash requirement. I have the option of selling an additional lot worth $5000 that incurred capital gains of $3000 or selling a lot worth $5000 that incurred capital losses worth $3000.

As far as I understand, the capital losses will be deducted from my capital gains for determining capital gains taxes and I will only have to pay the effective difference. However, if the additional stock I sold incurred capital gains too, and I kept the stock that incurred losses until the next tax year, I am able to sell that stock for a loss and deduct up to $3000 in losses from my regular income tax, which are generally much higher than capital gains taxes.

Let's assume we are in the highest capital gains and income tax brackets (20% and 37% as of 2018).

If I sell a lot with $3000 gains and a lot with $3000 loss, I will incur no capital gains taxes this year. But if I wanted to sell the other $5000 lot that incurred $3000 gains next year, assuming no additional gains/losses and changes in tax bracket, I will have to pay $600 capital gains taxes in total to liquidate all the stock worth $15,000.

If I sell both lots with gains this year for a total gain of $6000 in capital gains, I will owe $1200 in capital gains taxes. But if I then sell the $5000 lot that incurred $3000 in losses next year (again, assuming no additional changes), I will be able to deduct these $3000 from my regular income, on which I am paying 37% taxes, reducing my tax liability that year by $1110. This will reduce my total tax liability for selling $15,000 worth of stock to effectively $90.

Do I understand this correctly, or am I missing something?

Is it generally advisable to "cluster" sales of lots that incurred gains and losses (up to $3000) annually?

Answer 1

Your analysis is correct. In practice, however, other considerations often come into play. Possibly you're already aware of these things but just simplified matters for your question, so you may not actually be "missing something", but here are some relevant factors:

First, most people are not in the top tax bracket. If you are not in the top tax bracket, you have to consider the possibility that clustering all the gains into one year will push you into a higher capital gains bracket. This will depend on the precise amount of your ordinary income and the amounts of capital gains on the shares you may sell. Many questions about "how will this affect my taxes" are simpler if you are in the highest bracket, because nothing you can do will increase your marginal rate.

Second, in your example it just so happens that the amount of the capital loss on one lot is exactly the maximum amount that can be deducted against ordinary income. But of course, in reality, it might happen that the loss is more than that amount. Excess loss could then be carried forward to future years, but the longer you go on carrying forward such losses, the less clear it is that it is "worth it", because you have "locked in" a real loss in the here and now by selling your shares for a loss, while the tax savings are being deferred into the future. In addition, if you are already carrying forward a loss, additional net losses in future years provide you no immediate benefit. (That is, if you sell for a $6,000 loss this year, the tax benefit of selling for even a $100 loss next year becomes murkier, since you are already carrying forward $3,000 of loss from before, and thus any deduction for your extra $100 loss is already being pushed further into the future.)

Third, you begin by saying you are selling these stocks because you need $10,000 this year, but your subsequent analysis is based on selling $15,000 worth of stocks over two years. If your goal is to sell $10,000 worth of stocks this year, and you want to figure out the tax consequences of different ways of doing that, then selling the gains and losses together minimizes taxes, because you will incur no capital gains this year.

Fourth, the values of the stocks may change from one year to the next. This is related to the previous point, because it presumably would factor into your decision about how and whether to sell the stocks this year or next year. If you need $15,000 this year, you need to sell all three lots this year. If your only concern is needing $10,000 this year, you may not sell the other lot for many years, in which case it is more difficult to forecast the exact consequences, because it's harder to predict how much the stocks will be worth when you eventually sell them, and what other factors may be in play at that time.

Your analysis is really more pertinent if your goal is "I want to sell $10,000 worth of stocks this year, and $5,000 worth of stocks next year". And it's a good analysis of that. But there is the proviso that next year you could find that what you thought was going to be a $5,000 sale with $3,000 of gains could be a $10,000 sale with $8,000 of gains, or a $2,000 sale with no gain, or a loss, etc.

Finally, all of these considerations may interact. For instance, fluctuations in stock prices will change the amount of a gain or loss, and these changes themselves could change what tax bracket you wind up in, or change whether or not the loss winds up being fully deductible against ordinary income. Also, of course, unexpected gains and losses or other effects on tax decisions can occur in ways other than intentionally selling shares. (For instance, if these are mutual fund shares, the mutual fund may distribute an unexpectedly large capital gain to shareholders next year, offsetting the loss you were hoping to deduct against ordinary income.)

Answer 2

There is no general "right answer". Many times it depends on your other income in the same tax year. Balancing gains with other losses in the same tax year is effective at negating incoming taxes. But never forget the concept of opportunity costs; ask yourself if the equity you're selling for a loss to balance out the one that gained will not rise to the point of being a gain the following year? I would always pay taxes on a gain compared to getting a tax offset on a loss. Said another way, making 75% on a $10k gain (25% for taxes) is better than 100% on zero (no gain).

If you're in the top tax bracket and every gain now leads to high theft (uh, taxes), then it may be wise to offset gains with losses from dead-beat stocks (ones that you want to get rid of anyway). This is a good strategy.