Harvesting Mutual Fund Unrealized Losses to Offset Realized Capital Gains

As the holidays approach, so too is the annual ritual of that necessary task of year-end tax planning. This has become especially acute in today's investment market when so many portfolios have been ravaged by the fiscal upheaval of the times. This brings us to the year-end ritual of loss harvesting where we look to those securities whose values have declined below tax basis resulting in the all-too common unrealized losses. For those fortunate enough to have realized capital gains, loss harvesting becomes an important year-end consideration in providing some shelter against those gains. In harvesting such unrealized losses, there are two important considerations. The first is the age-old rule that the tax-tail should not wag the dog which means that investment considerations must take precedent over tax considerations. Once it has been decided to sell the loss securities, certain tax considerations come into play. For example, in the event a stock or security is purchased that is substantially identical to the stock or security sold and such purchase is within a period beginning 30 days before and ending 30 days after the sale, the loss from the sale is disallowed.

Although these rules (known as the "wash-sale" rules) are typically thought of in the context of individual security or stock sales, they also apply in connection with mutual funds. For example, reinvesting fund distributions into additional shares can sometimes cause mutual fund investors to run afoul of the wash sale rules if shares are sold at a loss with 30 days before or after an income reinvestment date. It becomes somewhat tricky when an investor acquires shares in a mutual fund that is different than the one from which shares are sold. The IRS has stated that taxpayers should consider all the facts and circumstances in determining whether such shares from different mutual funds are substantially identical to those shares sold from a different mutual fund. However, the IRS also stated that, ordinarily, shares issued by one company are not substantially identical to shares issued by another company. Presumably, one would consider each fund’s securities portfolio as well as other factors such as each fund’s expense ratios and transaction charges. For example, a mutual fund with a similar investment objective but with a different family of mutual funds than the one sold should not be substantially identical.

Finally, consideration must also be given to possibly higher capital gains rates in 2009 under the new administration. It has been suggested that Federal long term capital gains rates could increase to 20% in 2009 from the present 2008 rate of 15%. If such an increase in rates were to occur, realizing a capital loss in January 2009 may produce a larger benefit than realizing the loss in 2008. Of course, as capital losses cannot be carried back to prior years by individual taxpayers, there is a risk that capital gains will not be realized in 2009. In that situation, the taxpayer has foregone the 15% shelter in 2008 without the near-term 20% benefit in 2009.

To end on a positive note, hopefully by this time next year, you will find a much smaller unrealized capital loss crop from which to harvest!

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