The tax rule every investor should know in 2022
Investors suffered their longest bear market in years in 2022. Even after a significant rebound from the worst levels of the year, many stocks are still down sharply from their January level. This has investors looking for ways to take advantage of opportunities, and one thing they are looking at is doing year-end tax planning in hopes of paying less income tax next April.
In bear markets, many investors hold positions with substantial declines in value from where they made their initial investments. A strategy called tax loss harvesting can be a useful way to obtain at least a partial recovery of these losses.
Still, if you think stocks will rebound again, there’s one key tax rule you need to understand. Otherwise, you could lose the tax relief you were hoping to get.
Selling for tax losses and the wash sale rule
Individual taxpayers do not have to pay tax on gains until they sell their investments. At this point, they realize a capital gain or loss, depending on whether the value of the investment has increased or decreased since purchase. Before that, however, these gains or losses remain unrealized and you do not have to take them into account in your taxes.
This gives investors full control over their tax planning. When you have big winnings, you don’t have to pay taxes on them until you sell them. However, stick with it for the long haul and you’ll defer your taxes too.
The downside, however, is that for claim tax loss, you must sell. This is fine if you no longer wish to own shares, perhaps because you have lost confidence in the business prospects of the company. If you still like the company and expect the stock to rebound, the wash sale rule kicks in preventing you from simply selling your stock and buying it back immediately.
The washing rule instead requires that you have more than 30 days between when you sell the shares and when you buy replacement shares. Make the redemption before the 30 day period elapses and your tax loss on your original sale will be denied. The loss doesn’t go away, but it feeds back into the replacement stock tax base, locking it in until you sell those shares.
It’s hard to get around the wash sale rule
The rules of the wash sale also come into play in other situations. If you sell a stock and then buy an option within 30 days to buy that stock at a later date, this will trigger the rule. Sell the stock in one brokerage account and buy it back in another, and the rule still applies. Redeem a different class of shares of the same company — Alphabet Class A voting shares for Alphabet C non-voting shares, for example – and you also have your loss withdrawn as substantially identical security.
Therefore, you will usually only have to wait for the 30 day period. Still, this can cause problems if the timing of the tax-loss sale turns out to be bad. If the rally in the stock occurs during the period that you do not own the stock, then by the time you can buy the stock back, it could cost you much more than what you received from selling it a month before. .
A way to manage the risk of fictitious sales
A strategy that is allowed, however, is to buy shares of similar companies. So, for example, if you think Alphabet stock will rally when advertising picks up, you might consider owning shares of the social media advertising giant. Metaplatforms for the 30 day period. The hope of doing so would be that if Alphabet stock rises, Meta stock would follow for the same reasons.
The reason this is allowed, however, is also the reason it’s not a perfect solution. Meta and Alphabet are different companies that will operate differently. The shares could tender move similarly, but within any given 30-day period, it’s entirely possible that your replacement position will move in the opposite direction to that of the stock you sold.
However, with so many investors posting substantial losses in 2022, you can’t afford to overlook the opportunity to save tax by selling losing positions. As long as you follow the rules, you will be able to get something out of the loss of investments other than disappointment.
Randi Zuckerberg, former director of market development and spokesperson for Facebook and sister of Meta Platforms CEO Mark Zuckerberg, is a board member of The Motley Fool. Suzanne Frey, an executive at Alphabet, is a board member of The Motley Fool. Dan Caplinger holds positions in Alphabet (A shares) and Alphabet (C shares). The Motley Fool has positions in and recommends Alphabet (A shares), Alphabet (C shares) and Meta Platforms, Inc. The Motley Fool has a disclosure policy.