Beat the Crowd With This Smart Year-End Tax Move

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Many people have trouble thinking about taxes until the last possible minute. But you still have some time this year to do some do some things to cut your taxes next April.

The tax-loss harvesting strategy allows you to recover at least part of your losses from a bad investment by allowing you to claim a tax loss when you sell. But if you still believe in the long-term prospects for the stock in question, then there's a catch that snags many taxpayers by surprise -- and can end up costing you more than the tax break you get if you're not careful.

Understanding Capital Losses and the Wash-Sale Rule

In general, whether the price of a stock you own rises or falls doesn't matter as long as you own it. Dividends, interest payments and other income might get taxed, but the paper gains or losses on a stock don't affect your tax picture unless you decide to sell your shares. Once you sell, though, you'll generate a taxable capital gain or loss, depending on whether the stock has risen or fallen in value since you bought it.

If you've lost money, you can use the resulting capital losses to offset capital gains on other stocks you sell. In addition, you can use up to $3,000 of any remaining capital losses as a deduction against other types of income, including interest and even wage or salary income. Judiciously taking capital losses can save hundreds or even thousands of dollars on your tax return.

To claim a tax loss, though, a couple of things have to happen. First, you have to sell the stock before the end of the tax year, which for nearly all individual taxpayers is Dec. 31. Second, you can't buy back the stock until more than 30 days have passed after your sale. If you do, then you trigger what's known as the wash-sale rule, and you can no longer deduct the tax loss on your return.

The wash-sale rule prevents you from simply selling the stock and immediately buying it back, instead forcing you to go at least a short period without owning the stock. In many cases, that's not a problem, because you might not actually want to own that stock after its big loss. But if you think the stock will recover, some additional timing considerations come into play.

Seasonality's Greetings?

One phenomenon that many investors have noticed is that losing stocks often seem to lose even more ground toward the end of a year, only to pop upward at the beginning of the following year. Some analysts believe that this behavior is linked to tax-loss harvesting. Those who wait until the last possible moment to sell their losing stocks make their trades in December, and then have to wait until late January to buy them back. If the price has risen in the meantime, then it can mean missing out on share-price gains that would have been even larger than the amount of the tax break you receive.

This seasonal phenomenon doesn't happen every year. But even when it does happen, there's an easy way to beat it or even take advantage of it: Get your tax-loss harvesting done early.

For instance, if you sell stocks now, you'd be able to buy them back in late December, after more than 30 days. By then, you might be able to pay a lower price than you receive now, if further tax-loss selling activity depresses share prices further. By getting a jump on the crowd, you can benefit at their expense.

Losing money on investments is never a pleasant thing. But tax-loss harvesting can at least let you get a silver lining from your losses -- and using the strategy the right way can help you avoid what could become an even more costly mistake.

Motley Fool contributor Dan Caplinger believes in making the best of any losing situation. You can follow him on Twitter @DanCaplinger or on Google Plus. To read about our favorite high-yielding dividend stocks for any investor, check out our free report.
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