NEW YORK — This year’s steep drop for stocks means that so-called tax-loss harvesting is more popular than ever.

The tactic of selling securities at a loss to reduce long-term capital gains tax is a common year-end option for burned investors. As portfolio managers weed out losing stocks, financial advisors are hearing from a rising number of clients who want to know how to use the tax strategy to buffer losses.

Both stocks and mutual funds are fair game, though the rules are a bit different for each. Mutual fund shareholders may stand to benefit this year if they hold funds hit by a lot of redemptions.

Don Weigandt, wealth advisor at JP Morgan Private Bank in Los Angeles said his firm is doing tax-loss selling as it rebalances client portfolios as part of its third-quarter investment performance reviews.

“We expect to be doing more of this through the balance of the year,” said Weigandt.

As with any tax strategy, loss harvesting isn’t something that should drive investment decisions. Rather, Weigandt and other advisors say it should be used to complement an overall approach.

It’s particularly important this year to know what tax result will arise from selling a stock, according to Melbert E. Schwarz, national tax partner in the Washington, D.C. office of Grant Thornton LLP.

Keep good records and know how much of a gain or loss each sale will produce.

In order to figure capital gains on a stock, the taxpayer must know its cost basis, essentially the amount originally paid for it. Someone who sells a bunch of shares he bought in a company over time may have bought a few of the shares at $100, some at $50, some at $150 and some at $20.

“Obviously, I’m going to have different results for all these,” said Schwarz.

On stock sales, the taxpayer reports capital losses on Schedule D of Form 1040. Brokerage statements or confirmations from a broker who executed the trades is the usual documentation. Ideally, the record should show the taxpayer designated which shares he wanted to sell.

Currently, the only thing the broker reports to the Internal Revenue Service is the gross amount of proceeds from the sale. Starting in 2011, brokers will be required to report the cost basis of certain securities as well.

Taxpayers can claim a net capital loss of up to $3,000 each year. The loss offsets ordinary income that would otherwise be taxed at a rate as high as 35%. Losses over $3,000 can be carried over to subsequent years indefinitely.

Kaye Thomas, said many people have the misconception that they must limit losses to $3,000 each year.

“I tell people “No, it’s better to have a capital loss over $3,000, so that you have a capital loss carryover you can use in future years,’” says Thomas. “It expires when you do.”

On the other hand, a taxpayer with losses under $3,000 for the year may be tempted to sell additional appreciated stocks in order to “use” more capital losses in the current year. This isn’t a great idea if he doesn’t really want to sell the stock, according to Schwarz.

The wash sale rule is a potential tripwire in tax-loss harvesting. It penalizes anyone who sells a stock and buys it back within 30 days. A common strategy to avoid running afoul of the rule is to replace the stock that’s been sold with another that looks likely to perform the same way. Caveat: Using a too-similar stock breaks the rule.

Mutual fund investors who are thinking about harvesting their losses now may be better off waiting until they know more about how funds will handle their own capital gains, said Rich Rosso, a vice president and financial consultant in a Houston branch of Charles Schwab Corp. (SCHW).

Many fund companies will soon say whether they plan to pass capital gains from sales of stocks in the funds through to shareholders. Faced with a capital gains pass-through, an investor may want to switch to a more tax-efficient mutual fund or exchange-traded fund, said Rosso.

“It comes as a big surprise to some people when a fund they hold is down but they owe capital gains tax on it,” said Rosso.

End-of-year capital gain distribution by mutual funds can present a particular problem in down years like this. A mutual fund with a lot of redemptions may need to sell long-term holdings to raise cash. This results in capital gains that must be passed through to a smaller pool of shareholders.

Loss harvesting may be appropriate in such situations, according to Schwarz.

Mutual funds that tout themselves as tax-efficient, he added, can be particularly susceptible to this problem, because they may have avoided selling appreciated shares until forced to by net redemptions.

Extreme volatility in the stock market means there’s potential to be burned by tax loss harvesting now. The wash sale rule may prevent one who sells a stock from capturing an upswing days later.

On the other, it’s something that should get a look from anyone with big losses in a taxable account.

By Arden Dale
A DOW JONES NEWSWIRES COLUMN