Capital gains on investments held for one year or less are short-term capital gains taxed at ordinary income tax rates. For investments held over one year, the maximum long-term capital gains tax rate in 2010 is 15% (0% for taxpayers in the 10% or 15% tax bracket). While the 15% rate is significantly below the maximum ordinary income tax rate of 35%, it still takes a significant chunk out of your investment portfolio.
To help minimize your capital gains tax bill, you can actively harvest any losses in your portfolio. Some strategies to consider include:
Recognize losses to at least offset $3,000 of ordinary income. Keep in mind the tax rules regarding gains and losses - capital losses offset capital gains, and an excess of $3,000 of capital losses can be offset against ordinary income. If you are holding stocks with losses in your portfolio, you should probably take advantage of this tax rule.
If you still want to own the stock with the loss, you can sell the stock, recognize the tax loss, and then repurchase the stock. You just have to make sure to avoid the wash sale rules. These rules state that you must repurchase the shares at least 31 days before or after you sell your original shares to recognize the loss for tax purposes.
Consider recognizing all, or a substantial portion, of any losses in your portfolio. Realize that no one likes to sell investments at a loss. And since you can only offset an excess of $3,000 of capital losses against ordinary income, you might wonder why you should incur excess losses that can't be used currently, even though you can carry them forward to future years. There are a couple of advantages to this strategy.
First, it gives you an opportunity to totally reevaluate your portfolio. If you are convinced all your investments are good ones, you can sell them, recognize the tax loss, and then repurchase the stocks, being sure to invest the wash sale rules. But it's probably more likely that you own some investments you wish you didn't.
Second, it gives you more flexibility when recognizing gains in the future. Until you can use all of your capital losses, you can recognize capital gains without worrying about paying taxes. Even if your losses are long term, you can use them to offset short-term capital gains.
Use stock losses to offset other capital gains. If you have capital gains from the sale of another type of asset, such as a business or real estate, stock losses may be used to offset those gains.
Don't gift stocks with losses. If you are planning a large charitable contribution, it makes sense to donate appreciated stock held for over a year. You deduct the fair market value as a charitable contribution, subject to limitations based on a percentage of your adjusted gross income, and avoid paying capital gains taxes on the gain. If the stock has a loss, however, you should first sell it and then send the cash to the charity. That way, you get the charitable deduction and recognize a tax loss on the sale.