In December 1996, I sold a big position in Best Buy (NYSE: BBY) at a loss.
I still consider it one of the most boneheaded investment moves I ever made. A year later the stock was up more than fivefold. A few years further on, it was up more than thirtyfold.
I didn’t dislike the business prospects for Best Buy at the time. I sold it only because I had taken substantial capital gains elsewhere in my portfolio and was cleaning out anything I could find at a loss to offset them.[ad#Google Adsense 336×280-IA]It ended up being a costly mistake.
Despite what your tax advisor may tell you, you should never cash out of an investment for tax reasons alone.
Nor do you have to.
There’s a smarter way to protect your gains from the prying hands of the IRS.
The IRS allows you to offset realized gains with realized losses each calendar year.
(And take an additional $3,000 against earned income.)
If you sell for tax purposes, however, you must wait at least 30 days before buying the same shares back. Otherwise you run afoul of the wash-sale rule.
Offsetting gains at the end of the year is often a sensible move. Most stocks are not appreciably higher 30 days later. If you still like them, you can buy them back then.
There is a risk, however, and it’s called the “January effect.” The first month of the year is traditionally a strong one for the market. A lot of pension and IRA money gets invested early each year. Plus, there is often a rebound from the tax-loss selling that goes on each December.
If a stock you own soars in January, there is a natural reluctance to buy it back. The temptation is to wait until it comes back down. But what if it doesn’t? You’ve taken a limited loss but sold an investment with unlimited upside potential.
There is a way around this problem, however. And you can take advantage of it – but only if you’re willing to move in the next six weeks.
Each fall, I look at my non-retirement accounts for stocks that are trading below my entry price but not near my trailing stops. If I still like a stock, I often make the decision to double down on it for 30 days.
Why? Because I can sell the original shares at the end of December for a tax loss. And if the stock rallies in January, it’s not a problem. After all, thanks to my purchase in October or November, I still own the same number of shares I bought originally – and I now have a lower cost basis as well.
What if you don’t have the cash to double down on your position? Use margin. Again, I’m recommending this only for a 30-day period. So your margin interest charge would be minimal.
The risk, of course, is that your shares will be worth less in late December and you will have a paper loss on the second purchase.
However, just the opposite may happen. Remember, the January effect is often preceded by the Santa Claus rally, the tendency of the stock market to do well in the second half of December. As a result, you could end up with a smaller loss on your original shares and a paper gain on your second purchase.
(The Santa Claus rally and the January effect, while real seasonal trading patterns, are never certain of course, and another reason why you should add to only those companies whose earnings prospects remain strong.)
Bear in mind, when selling for tax purposes, the IRS requires that you buy those identical shares AT LEAST 30 days before you sell the others. So if you want to use this strategy for 2013, you must act over the next six weeks.
If we have the traditional mid-December to early February rally, you’ll thank me. And again, perhaps, on April 15.
Source: Investment U