Though 2020 was certainly a rocky year for investors, with stock values plummeting as the COVID-19 crisis expanded into a pandemic, the market has recovered nicely since its spring nadir. Now, a lot of investors are looking at stocks in their portfolios trading at or near record highs.

If you’re thinking of cashing out of some of those investments while they’re up, don’t forget to consider your choices from a tax perspective.

Whenever you sell investments for more than what you paid for them, you’re liable for taxes on your capital gains.

The tax rates on those profits are highest for investments held for a year or less before being sold.

But even long-term capital gains — those that apply to investments that are held for at least a year and a day — are subject to taxes that could result in quite a big IRS bill.

If you made a lot of money in stocks this year and want an easy way out of paying the resulting taxes, there’s one solution you can employ — and it’s totally legal.

Use losses to offset gains

Every investor wants to choose stocks that either pay strong dividends, rise in value, or both. But if you have a number of investments in your portfolio that have lost value and that you view as unlikely to become winners anytime soon, then selling them at a loss could turn an otherwise painful tax situation into a more tolerable one.

By selling stocks at a loss, you offset the taxable value of your capital gains. So if, for example, you’ve decided to lock in gains of $6,000 from some of your winners by selling shares, but you can also close out positions that give you a $6,000 loss, from a tax perspective, your capital gains are zero. The extra tax burden from your profitable investments is gone, and you’ve freed up the money that was tied up in those losing stocks to be reinvested in (hopefully) better ones.

Now, you may land in a scenario where your unrealized investment losses exceed your gains. That situation can have its silver linings, too. Say you’re sitting on a $6,000 loss with only $5,000 in gains. If you sell both the winners and losers, after the $5,000 in capital gains is canceled out, you can apply your remaining $1,000 loss to your ordinary income. The U.S. Tax Code allows you to use investment losses to offset up to $3,000 of ordinary income per year.

Another thing you should know is that you don’t need to use up your entire capital loss for the tax year in which you take it. Say you take a $6,000 loss this year, but you only have $2,000 in capital gains to negate. From there, you’re left with $4,000, of which $3,000 can be used to offset ordinary income. But you don’t lose the remaining $1,000 tax benefit. Instead, you can carry it with you into 2021 and use it then.

Of course, you’ll often hear that selling investments at a loss is something you should try to avoid — especially if there’s the possibility that the stocks in question will recover. But if you’re sitting on losing stocks with a negative outlook, then unloading them before the end of the year could make a lot of sense, especially if you already know you’ll have capital gains to declare for 2020. Even if you think those stocks may eventually recover, it could still make sense from a tax standpoint to take the loss and look for investments with greater potential.

So weigh your options and, if you’re going to need to book those losses, move quickly. You only have one more week to change your 2020 capital gains tax situation for the better.

— Maurie Backman

Where to Invest $99 [sponsor]
Motley Fool Stock Advisor's average stock pick is up over 350%*, beating the market by an incredible 4-1 margin. Here’s what you get if you join up with us today: Two new stock recommendations each month. A short list of Best Buys Now. Stocks we feel present the most timely buying opportunity, so you know what to focus on today. There's so much more, including a membership-fee-back guarantee. New members can join today for only $99/year.

Source: The Motley Fool