The Tax Law Every Investor Must Understand in 2022

 

2022 marked a challenging year for investors, with one of the longest bear markets in recent memory. Despite a notable recovery from the year’s lowest points, numerous stocks still lag significantly behind their January levels. This situation has prompted experienced investors to explore year-end tax planning as a means of potentially reducing their income tax burden in the upcoming April filing. In bear markets, investors often find themselves holding positions that have significantly declined in value from their initial investments. To recoup at least a portion of these losses, investors frequently turn to a strategy known as tax-loss harvesting. However, if you believe that stocks will experience further rebounds, it’s crucial to grasp a key tax rule. Failing to do so could jeopardize the tax benefits you’re hoping to leverage.

Selling for Tax Losses and the Wash-Sale Rule For individual taxpayers, taxes on gains are only due when they sell their investments.

At that moment, they realize either a capital gain or loss based on the investment’s change in value since purchase. Until then, these gains or losses remain unrealized, exempt from tax considerations. This arrangement grants investors full control over their tax planning. If you have substantial gains, you only pay taxes when you decide to sell. Holding onto investments for the long term allows you to defer taxes as well. The downside is that to claim a tax loss, you must sell your investment. This is acceptable if you no longer wish to own the shares, perhaps because you’ve lost confidence in the company’s future prospects. However, if you remain optimistic about the company and anticipate a stock rebound, you’ll encounter the wash-sale rule, which prevents you from merely selling and immediately repurchasing your shares. The wash-sale rule stipulates that there must be a period of more than 30 days between selling the stock and buying replacement shares. If you repurchase the stock within the 30-day window, your initial sale’s tax loss will be disallowed. The loss doesn’t vanish; rather, it is incorporated into the tax basis of the replacement shares, essentially locking it away until you sell those shares. Dealing with the Challenges of the Wash-Sale Rule Wash-sale rules also apply in other scenarios. If you sell a stock and then purchase an option to buy that stock at a later date within 30 days, the rule is triggered. Selling the stock in one brokerage account and repurchasing it in another also falls under the rule’s purview. Even buying a different share class of the same company, such as Alphabet Class A voting stock and Alphabet Class C non-voting stock, can result in your loss being disallowed as a substantially identical security. As a result, in most cases, you’ll have to patiently wait out the 30-day period. However, this can present challenges if the stock rebounds while you’re on the sidelines, as by the time you’re able to repurchase it, the price could be significantly higher than what you received from selling it a month earlier.

A Strategy for Navigating Wash-Sale Risks One permissible strategy is to purchase shares of similar companies. For example, if you believe that Alphabet stock will rebound when advertising demand picks up, you might consider holding shares of Meta Platforms, a social media ad giant, for the 30-day waiting period. The idea here is that if Alphabet stock rises, Meta stock may follow suit for similar reasons. However, it’s important to note that while this approach is allowed, it’s not without its flaws. Meta and Alphabet are distinct businesses with their own performance dynamics. Although their shares may exhibit some correlation, there’s no guarantee that your replacement position will move in the same direction as the stock you sold during a given 30-day period. Given the substantial losses many investors experienced in 2022, it’s essential not to overlook the opportunity to generate tax savings by divesting losing positions. As long as you adhere to the rules, you can potentially derive some benefits from underperforming investments, instead of experiencing pure disappointment.

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