Near the end of January, custodians will send Form 1099 tax statements to investors. 1099s detail income from investments in several sections. The 1099-DIV lists dividend income from stocks, and the 1099-INT shows interest income from bonds and money market funds for the year. The 1099-B is the section which summarizes realized capital gain and loss activity. Investors with capital gains and losses in their portfolios need to make an important distinction when reviewing their 1099s: capital losses are not the same as negative portfolio returns.
What is a Capital Loss?
A capital loss arises when you sell an investment for less than you paid for it. Whereas a capital gain occurs when the sale price exceeds the purchase price. Gains & losses are either short-term, or long-term, and the difference is whether you held the investment for 365 days or more. From a tax standpoint, the total of all short-term gains is first matched with the total of short-term losses. The result is either a net loss or a net gain. The same process holds for long-term gains and losses. Finally, the long-term position is netted against the short-term position, and the result is either an overall net capital gain or loss, and can be short-term or long-term. This is a big distinction, because a net overall long-term gain position will be taxed at a lower rate than a short-term gain.
Using Losses to Your Advantage
As we wrote about in Using ETFs to Avoid Wash Sales, capital losses can be very valuable as part of a sound tax strategy. No one wants to realize a loss, but they are also inescapable over time. Because capital losses are inevitable for investors, it is important to know how to use them well. The stock market correction during the fourth quarter of 2018 offered investors an opportunity to “lock-in,” or realize, losses to offset gains. When losses are available to reduce taxes, we try to use them in appropriate situations. At Peloton we prioritize sound investment decisions over loss harvesting, and not all losses are “worth” realizing. If the loss is small relative to the size of the position, or if there isn’t a suitable proxy for the stock, it may be better to hold rather than sell simply to realize a loss.
When a Capital Loss Doesn’t (Really) Hurt
Let’s look at a brief example to distinguish between capital losses and returns. Suppose on January 2, you buy 100 shares of XYZ Corp. for $10 per share: a total investment of $1,000. Let’s say in August, you notice that XYZ Corp. is now priced at $8 per share, which means your investment is worth $800. After you determine that XYZ’s problems are significant, you decide to sell at $8 per share. You feel a sense of regret because you lost $200.
Because you understand that market timing is a fool’s game, you immediately reinvest your $800, buying 100 shares of ABC Co. at $8. When you look at your investment months later, you notice happily that ABC has done very well, rising to $12 per share. You have gained $400 on this investment and now feel great.
Despite realizing a loss on XYZ, which you’ll see on your 1099, you should feel pretty good about the year. Your total investment gained 20% ($1,200 vs. $1,000). But you should feel better still, because you can use the realized capital loss on XYZ to offset other realized gains or ordinary income. You won’t owe any tax on ABC until you sell it.
While capital losses ultimately reflect an economic loss, they are unavoidable, and can be managed for useful ends. The key when determining how your investments are performing is distinguishing between capital gains and losses for tax purposes, with what your return has been.