The Reluctant Investor
December Pruning and Taxes

The Reluctant Investor courtesy of

In December, jingle bells will be jingling for some investors, while the bells are tolling for others. Whichever way the seasonal bells ring, you can parlay your barking dogs (losing stocks) into Yuletide tax breaks.

At the end of the year, Uncle Sam lets you write off up to $3,000 worth of capital losses (which include securities losses). Not a bad time to dump some of that coal in your stocking.

Tax-lot accounting is a record keeping technique that traces the dates of purchase and sale, cost basis and transaction size for every security in your portfolio, even if you make more than one trade in the same security.

A tax-lot, simply, is a block of shares. If you buy 300 shares of a security in blocks of 100 over the course of a year, you will wind up with (surprise) three tax-lots bought at various prices (unless, of course the price remains completely static).

The goal of tax-lot accounting is to minimize the net present value of your taxes now; deferring the realization of capital gains and recognizing losses sooner.

In the following example, "Jim" purchases three lots of his favorite stock, Newbie Tech (RI:NTCH). The current price is $90 and trade volume is consistently high. You can see Jim minimizes tax liabilities by selling off a losing lot, and holding winners - a technique that seems obvious, but many people miss.

Newbie Tech (RI:NTCH)

All of the transactions occured within the last 12 months, making them all short term gains and losses (the IRS categorizes investments over 12 months old as long term). The importance of long and short term gains and losses lies in the fact that long term gains typically get taxed at 20% (a lower rate than most investor's marginal tax rate) and short term gains get taxed according to the investor's income level.

Two Strategies

If Jim realizes lot three this year, he pays taxes on the $800 gain. If Jim then realizes lot two, say the following year, he again pays taxes on the $200 gain. Finally, the stock seems to be going nowhere and, the following year, Jim realizes the $1,000 loss on lot one. Jim now has lost $1,000 and subsequently paid taxes on $1,000 in gains he no longer has.

If Jim had used basic tax-lot accounting methods, he would have realized his loss earlier. He can claim a realized loss (up to $3,000) against the following year's return. Thus, if he realizes lot two for a $200 gain after realizing lot one a year earlier, he will not owe capital gains taxes on the proceeds. He is also giving himself a chance for greater success - owning stocks with a lower cost basis does not guarantee profits, but does make it easier to win than if he held the $100 lot.

There are a myriad of things Jim could have done, and these are but two examples. What's best for you will be determined by your portfolio and personal risk factors.

Having your lots organized, though, helps you minimize the impact of taxes and allows you to beat (well, at least a little bit) Uncle "Ebenezer" Sam.

Resources:

• The IRS, surprisingly enough, has an excellent description and detailed example of a 1997 Schedule D (the tax form associated with such transactions).
  
  
• Smart Money has information on the new tax laws and a fun long term/short term calculator that will determine the amount you owe on capital gains.
  
  
• While tax-lot accounting is easily performed with a pen and paper, AMEX and Lindner both offer it as a standard feature of their portfolio management - a nice touch that will help you better manage your money.

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