Is “Don’t Die with Capital Loss Carryovers” a Good Rule to Live By?

Question

In 2023 “Last-Minute Year-End Tax Strategies for Your Stock Portfolio”, you state in Strategy 4, “Don’t die with Loss carryovers.”

I ask, “Why not?”

Let’s say I have $400,000 in capital loss carryovers, and a stock portfolio worth $2 million with a basis of $1 million.

I sell $800,000 worth of stock to generate a $400,000 gain, use my $400,000 carryover loss to avoid taxes and spend $800,000 to buy back that stock the next day. (The wash sale rule does not apply to gains, so the buyback causes no tax problems.)

After this transaction, the loss is gone and I have the following:

• Result 1. Say I die a day later. My heirs get a step-up in basis and inherit the stock with a basis of $2 million.
• Result 2. Say I didn’t sell the stock before I died. The $400,000 capital loss carryover goes away at my death. My heirs inherit the stock with a stepped-up basis of $2 million

In both results, there’s no difference between dying with or without the capital loss carryover.

And now let me one-up this in two different ways.

Let’s say I’m married, I live in a community property state, and my spouse has a community property interest in the stock portfolio. My spouse gets a step-up and inherits the stock portfolio with a basis of $2 million and also keeps $200,000 of the capital loss (her half).

Key Point: My spouse won a $200,000 capital loss carryover because we did not eliminate the carryover loss before my death.

Now let’s say I’m married, I own the stock jointly with my spouse, but I live in a non-community property state. At my death, my spouse inherits my half at a stepped-up basis of $1 million and also has her half, which has a market value of $1 million. At the date of my death, my spouse’s position looks like this:

• Value of stock portfolio: $2 million
• Basis in stock portfolio: $1.5 million ($1 million from the estate + $500,000 from ownership)
• Capital loss carryover: $200,000 (spouse’s half)

Had we sold the stock for a gain of $400,000 ($800,000 – $400,000) and not repurchased it before I died, my spouse’s position would look like this:

• $2 million in assets ($600,000 of inherited stock + $600,000 from 50 percent interest owned + $400,000 cash from sale + $400,000 cash inherited)
• Basis in stock portfolio: $900,000 ($600,000 from the inherited stock + $300,000 from joint ownership)

Again, I’m ahead by not selling the stock to eliminate the loss. (Well, technically my heirs are ahead because I’m dead.)

From what I see, the examples above show it’s better not to sell stock that eliminates the capital loss carryovers. Do you agree?

Answer

Yes, we agree.

While researching your comments, we found that almost all advisors recommend the use of the capital loss carryover but no one with your take that this is not only unnecessary but damaging, as your examples show.

We should also note that we did not see those advisors use a pencil-to-paper analysis such as you laid out.

Takeaways

To use or not use capital loss carryovers before death requires a pencil-to-paper analysis. Without such analysis, it’s far too easy to gravitate to taking the loss when it

• Has no benefit for either the income tax or estate tax return, and
• Tobs the surviving spouse of the net operating loss (NOL) portion he or she owns.

Keep This Rule in Mind: the NOL carryover is deductible only by the taxpayer who sustained the loss. With community property or other joint ownership, you either take the loss on a joint return or allocate it to the ownership parties. At death, the survivor retains his or her NOL.

In the intricate world of financial decisions, determining whether to sell your stocks or retain those capital loss carryovers can be a real puzzle.

If navigating this intricate web of tax strategies feels like tiptoeing through a minefield, consider seeking the guidance of seasoned professionals, why not chat with the folks at Morris + D’Angelo? Discover how our expertise can be your ticket to financial success and wealth preservation! Your peace of mind is just a click away.

Parts of this article are published with permission from Bradford Tax Institute, © 2021 Daniel Morris, Morris + D’Angelo

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