A couple of weeks ago when talking about the tax implications of capital gains, I said you should "shoot for long-term gains and short-term losses."
Since that column appeared on Nov. 29, several readers have asked me to explain the rationale behind that statement.
The secret is in the mechanics of Schedule D, the form used for reporting capital gains and losses to the IRS as a part of your annual income tax return.
You should know first that a short-term gain or loss results from the sale of an asset you have owned for a year or less. Disposition after more than a year of ownership creates a long-term gain or loss.
If you have a short-term gain, the amount of the gain is added in full to other income and is taxed at your regular rate. Similarly, you subtract the entire amount of a short-term loss from other income, so it is all used to reduce your tax.
If sale of an asset results in a long-term gain you subtract 60 percent of that gain on Schedule D and only carry the remainder forward to Form 1040 to be added to other income.
So only 40 percent of any long-term gain is subject to tax. That means that if you're in the 39 percent tax bracket, you end up paying only 15.6 percent tax on the total gain -- 40 percent of the gain times 39 percent tax bracket.
(It's this arithmetic that led to announcement last year that the capital gains tax had been cut to 20 percent. The top tax bracket for 1982 was dropped to 50 percent; you pay tax on only 40 percent of capital gains; and 50 percent of 40 percent works out to a 20 percent maximum.)
The fourth possible result of a capital transaction is a long-term loss. In this situation you divide the loss in half and carry 50 percent of the total to the 1040 to reduce your taxable income.
With that explanation you can see that a short-term loss is better for tax purposes than a long-term loss. Short-term gives you a 100 percent write-off against other income as opposed to only a 50 percent write-off from a long-term loss.
Conversely, if you have a capital gain, long-term is the better way to go, because you'll only have to include as income -- and pay tax on -- 40 percent of the total gain. If you sell an asset for profit within a year after acquisition, the entire gain is subject to tax.
Hence, the normal rule: "Shoot for long-term gains and short-term losses."
But having taken you this far and convinced you of the wisdom of this basic rule, I must pursue the subject further -- even at the risk of muddying the waters.
If you do much trading in securities or other investment assets, you should keep a running tally all year of your gains and losses, differentiated as to long-term and short-term.
That's because you do not carry the result of each independent transaction to Form 1040 separately. Instead, you list all transactions on Schedule D and "net" gains against losses and long-term against short-term. And that balancing out is done before you apply the various percentages mentioned earlier.
So if the present balance of all your transactions for the year shows a net short-term gain, the full amount will be added to taxable income.
But if before the end of the year you can sell an asset that produces a long-term loss, 100 percent of that loss can be used to wipe out the short-term gain.
That's a pretty good bonus, considering that standing alone only 50 percent of the long-term loss may be applied to reduce other income. In effect, the loss does double duty on Schedule D.