Hidden Capital Losses

Hidden capital losses have the opposite effect from hidden capital gains. For example, a mutual fund with an NAV of $10 per share at the beginning of the year might accumulate capital losses of $3 per share because of a declining market in which investments are sold at a loss during the year. If you purchased the shares at $10 per share and sell them at $7 per share, you have a capital loss of $3 per share. You can use this loss to offset capital gains or income up to the allowable limit ($3,000 for 2005). However, if you buy shares at $7 per share and then sell them later at $14 per share, you have a capital gain of $4, not $7, per share. The reason is that the fund has accumulated a $3-per-share loss, which means that the adjusted cost basis of the shares in the fund is $10 (the capital loss is added to the cost of the shares).

Unrealized capital losses in a mutual fund offer potential tax savings for investors in a fund in the same way that unrealized capital gains offer tax liabilities to investors in a fund. Table 14–7 summarizes investment strategies that take advantage of the existing tax treatment of investment income.

Table 14-7
Tax-Efficient Investing Strategies
Successful investing requires building a portfolio of securities that can generate healthy after-tax returns for long periods of time. This is more than merely minimizing taxes on dividends received and capital gains. For stock investments, a tax-minimization strategy would be to buy stocks that pay dividends and offer the prospects of long-term capital gains because both dividends and long-term capital gains (if held for more than one year) are taxed at lower rates than interest income. However, in the early 2000s, with the decline in the stock market, there has been a greater focus on dividend-paying stocks, which tend to drop less in price than growth stocks that don’t pay dividends. Thus one approach to a declining stock market is to focus on quality stocks that pay dividends.
Hold appreciated stocks for at least one year to take advantage of the favorable capital gains tax rates. If the stock has appreciated and the future prospects for the stock do not look good, sell the stock even if you have held it for less than one year. It is better to have short-term gains than long-term losses.
If you have stocks with losses and the stocks’ future prospects are not good, sell them to take the losses. You can use these losses to offset capital gains. In addition, you can use losses exceeding capital gains to offset income up to $3,000 (married filing jointly) or carry the losses forward indefinitely to offset future gains. Timing your gains and losses can reduce the amount of your taxes. If you have large capital losses, you can sell stocks with large capital gains to offset those losses.

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