During a year like 2011, when the stock market has seen significant volatility, investors have likely realized both capital gains and losses in their portfolios. The tax rules regarding harvesting losses can be confusing, but understanding them can help make sure you’re getting the biggest tax benefit possible.

Netting Gains and Losses
Capital gains and losses can generally be used to offset each other for tax purposes, but it’s important to first understand the type of transaction. Capital transactions are always grouped according to how long the position was held – either short-term (held for one year or less) or long-term (held for more than one year). Short-term gains and losses are combined to determine a net short-term result. The same occurs with long-term gains and losses. If after this netting there are gains in both categories, short-term gains are taxed as ordinary income, and long-term gains are taxed at the applicable rate (typically 15%).

If the above process results in a gain in one category and a loss in the other, the next step is to combine the short- and long-term amounts. If that combination results in a net gain, it’s taxed as described above, based on the type of gain.

If that step results in a loss, up to $3,000 ($1,500 if married filing separately) can be used to offset any other income you may have, including wages and retirement income. Net losses in excess of that amount must be carried forward indefinitely to offset gains or other income in the future.

Avoiding Wash Sales
The wash sale rules were designed to prevent someone from selling a position just to realize a tax benefit from a loss and then repurchasing the same position right away.

The wash sale rules can be triggered any time you sell something for a loss. When the sale occurs, you are prevented from purchasing a “substantially identical” position to what you just sold. “Substantially identical” isn’t perfectly defined, but includes the exact same position, as well as options or other items that are deemed close enough to be essentially the same holding.

If a wash sale occurs, the realized loss is not deductible. Instead it is added to the cost basis of the newly purchased position. As a result, the loss is deferred until the replacement position is eventually sold. A wash sale can occur when one spouse buys and the other sells the same position, or even when the repurchase happens in an IRA.

The time period during which you can trigger a wash sale begins 30 days before the loss is realized, includes the day of sale, and extends for 30 days after the sale – a total of 61 days. In other words, you can trigger a wash sale by doubling up on a position before you sell it.

Specific Strategies
There are a few ways to avoid wash sale treatment. Purchasing the same position more than 30 days before the sale allows you to remain an owner of the stock while still taking a deduction for the loss. If you’ve already sold a stock at a loss, you could immediately replace that with another stock in the same industry, or with an ETF or mutual fund that tracks that industry. If you sold an actively managed mutual fund, you could purchase another fund with a similar mandate or target benchmark.

Realizing losses to offset gains can be an effective tax planning strategy, as long as it’s implemented carefully. Your Baird Financial Advisor can help you understand where you stand today, and what opportunities might exist to reduce your capital gain tax liability.

Investors should consider the investment objectives, risks, charges and expenses of exchange-traded funds (ETF) carefully before investing. This and other information is found in the prospectus. For a prospectus, contact your Baird Financial Advisor. Please read the prospectus carefully before investing.

ETF’s are subject to the same risks as their underlying securities and trade on an exchange throughout the day. Although investments in ETF’s may gain exposure to the same sector as an individual stock, the correlation may be minimal due to a high number of holdings.