Active investors probably have a better opportunity than others to modify their tax liability at year's end. But even if you're only an occasional dabbler in stocks and bonds, you should know the tax rules: Timing can make a considerable difference in the net results.
First a warning: Don't let tax considerations cloud your investment judgment.
The impact of the tax regulations should be considered in your investment planning, but should not be the prime determinant and should never be permitted to overshadow performance or other market factors.
The first step is to sort out all the investment transactions made this year that generated either a capital gain or a capital loss. All your gains and losses -- regardless of whether they are short term or long term -- can be balanced against each other to determine whether you have a net loss or net gain.
The Tax Reform Act of 1984 introduced a new complication, changing the holding period used to distinguish between short term and long term from one year to six months -- but effective only for assets bought after June 22, 1984.
For example, if you sell a stock that you already owned on June 22, the old one-year rule applies before the stock goes long term. But if you bought the same stock after June 22, any gain or loss is long term on a sale any time after the new six-month holding period.
From a tax point of view, the objective is to make all gains long term. You only pay tax on 40 percent of a long-term capital gain, so the maximum tax -- for a taxpayer in the 50 percent bracket -- is 20 percent.
On the other hand, if you must accept a loss, short term is better than long term. A short-term loss may be used dollar for dollar (up to the $3,000 annual limit) to offset other income, but only 50 percent of a long-term loss may be applied.
If your records show that you have a net short-term gain, review your portfolio to see if you can generate a long-term loss by selling one of your holdings. All of the short-term gain is subject to tax; but all of a long-term loss may be applied against the short-term gain.
So, in effect, you are converting a 50 percent deduction (that's all you get when you use a long-term loss to offset other income) into a 100 percent deduction by balancing it against what would otherwise be a 100 percent taxable short-term gain.
Don't go in the opposite direction. If you have a long-term capital gain, wiping it out with a short-term loss will cost you tax dollars. The short-term loss by itself can reduce other income dollar for dollar; but only 40 percent of the long-term gain is taxable anyway. So, in effect, you would be using what could be a $1 deduction to eliminate only 40 cents in taxable income.
The rules governing close-out dates for year-end stock transactions were changed late in 1983. If you sell securities at a loss -- whether short or long term -- the loss is recognized for income tax purposes on the trade date. So you have until Dec. 31 to order a sale and the gain or loss still goes into 1984.
Until the rules were changed, a gain wasn't recognized until the settlement date -- five business days after the sale. Under the new rule, however, you have a choice of reporting the gain in either year when the trade date is in 1984 and the settlement date in 1985.
As a result of a redefinition of installment sales in the Economic Recovery Tax Act of 1981 (ERTA), a market trade of a security late in December 1984 with settlement in January 1985 qualifies as an installment sale.
And because it qualifies as an installment sale, you can report the gain in 1985 -- the year you receive payment. But you have the option of not considering it an installment sale, which then permits you to include the gain on your 1984 return.
There is no need to identify your decision to the IRS. Entering the sale on your 1985 Schedule D indicates that you are treating it as an installment sale; including it on your 1984 return shows your election not to treat it as an installment sale.