Don't Buy that Stock!
by Douglas Gerlach
Year end selling might reduce your tax bill, but watch out for the wash sale rule.

At the last meeting of my investment club in 1998, we voted to sell two stocks at a big loss. We actually think the stocks still have a lot of future potential for growth -- so why did we sell them? Both stocks had declined significantly in price, so selling our would generate a "tax loss" to offset some of the profits we had made earlier in the year. And that would reduce our tax bill! After all, it doesn't make sense to give Uncle Sam any more of our profits than we have to!

We also decided that we would re-evaluate both stocks at our January meeting, and perhaps re-purchase them for our portfolio. If we do decide to buy back our shares, we'll have to watch out for one important hazard -- the "wash sale rule."

Many investors undertake a similar year-end ritual each December known as "tax-selling." But before you repurchase any security that you sold for tax reasons, you'll have to know how the wash sale rule works.

When you sell a stock or mutual fund at a profit, those profits are known as "capital gains." Mutual funds are required to make regular distributions of capital gains to their shareholders, too, so you may have capital gains taxes to pay even if you never sold any of your mutual funds.

The tax rate you'll pay on your capital gains depends on whether they are long-term (you held the security for longer than 12 months) or short-term (you owned the stock for less than 12 months). The long-term capital gains tax rate is now 20 percent, while short-term capital gains are taxed as "regular income" (just like your paycheck) at your federal tax rate.

Capital losses, on the other hand, are what occur when you sell a stock or mutual fund at a loss. The good thing about capital losses is that they can reduce the taxes you pay! Capital losses can be used to offset all the capital gains you have. You can even use up to $3,000 of your losses in a year to offset regular income, thereby reducing your taxes still further.

If you have a lot of capital gains, it can make a lot of sense to look at your portfolio and sell shares just to generate a loss for tax purposes. If it's a stock or fund that you really want to own, you can buy it back later -- but this is where the wash sale rule comes in. The IRS says that you have to wait for 30 days after you've sold a security for a tax loss until you repurchase the same (or "substantially identical") security. In the case of my investment club, if we decide to repurchase one or both of the stocks, we'll be sure to wait until the 31st day after we sold the shares to make the new purchase.

The "substantially identical" rule means that you can't take a tax loss and buy a mutual fund within 30 days if the new fund is essentially the same as the fund you sold. In other words, you can't sell one S&P; 500 index fund and repurchase an S&P; 500 index fund from another company the next day and still take the tax loss.

If you violate any of the provisions of the wash sale rule, your loss will be disallowed.

There are a couple of other points you should consider on the topic of wash sales: And remember this cardinal rule of tax selling: you'll never get rich taking tax losses!