Tax Matters

Last weekend I got together with friends and we played a game. The object was to share a unique piece of information about any topic. Now, my friend Jim shared all you could ever want to know about the levator labii superioris alaeque nasi. If that term doesn't put a smile on your face, you should worry. As it turns out, he was talking about one of the muscles in your face that allow you to smile. When it was my turn, I shared a tax strategy that very few people think about. (Note to self: Stay far away from Tim and his friends. They know nothing about having a good time.)

Let me share that strategy once again. It's the perfect time of year for this one.

The Concept

Picture this. Your spouse has capital gains on which he'll pay tax this year. Or perhaps he's reported capital gains in the last three years (2009, 2008 or 2007). You, on the other hand, have capital losses to use up, but no capital gains against which to offset those losses. So, your spouse could end up paying tax on those gains even though, as a couple, you may not have made any profits.

You can solve this by transferring capital losses from one spouse to the other. The capital losses could then be applied to reduce the capital gains of the other spouse. It's also possible to carry capital losses back up to three tax years, to recover taxes paid in a prior year. Keep in mind, the capital losses must be on paper only (not actually realized) in order to use this strategy. The exception is where those losses were realized in the last 30 days, in which case there may still be time to implement the idea.

The Example

Jackson owns shares in XYZ Corp. that are worth \$30,000 today. He paid \$70,000 for the shares, so he has an unrealized capital loss of \$40,000. His wife, Nancy, reported capital gains on her tax return last year of \$40,000. If we could just transfer Jackson's \$40,000 capital loss to Nancy, she could then report that loss on her 2010 tax return and carry the loss back to 2009 to recover the \$9,280 in taxes she paid last year on that capital gain. How can this be done? Easily, in three steps.

Step 1: Sell your securities. Jackson is going to sell his XYZ shares on the open market for their fair market value of \$30,000. This will cause him to realize his \$40,000 capital loss. But we don't want to stop there. After all, Jackson doesn't need the capital losses - Nancy does.

Step 2: Your spouse buys them back. Nancy will now purchase on the open market the same class of XYZ shares that Jackson sold. So, Nancy will pay \$30,000 to purchase the XYZ shares. At this point, our tax law will cause Jackson's \$40,000 capital loss to be denied. You see, if you sell a security at a loss and then you, or someone affiliated with you (including your spouse), acquires that same security within 30 days following your sale (or 30 days prior to your sale), your loss will be denied under the superficial loss rules.

But the loss is not gone forever. Under our tax law, the \$40,000 capital loss is added to the cost amount of the newly acquired shares. So, even though Nancy paid \$30,000 for the shares, her adjusted cost base (ACB) will be \$70,000 (the \$30,000 she paid, plus the \$40,000 loss that was denied). This way, Nancy will get the benefit of the loss when she eventually sells the shares (the higher ACB will reduce a gain or increase her loss at that time).

Step 3: Your spouse sells. Nancy will now sell her XYZ shares. Don't forget, the value is \$30,000, but her ACB is \$70,000, so she'll have a capital loss of \$40,000 which she can use to offset her gains. Presto. Jackson has transferred the capital loss to Nancy.

Keep in mind, the timing matters here. The clock starts ticking at Step 1 when Jackson sells. Step 2 must take place within 30 days of Step 1. Then, Step 3 must take place after the 30th day. So, Jackson could have sold on Day 1, Nancy could have made her purchase on Day 29, and then sold the shares two days later on Day 31. You should aim to implement Step 1 by Nov. 20 to make sure this whole strategy can take place in 2010.