"Underperforming" stock is a euphemism for a stock in which an investor has a loss -- it's down from the price at which the investor bought. "Underperforming" stock can also mean a stock that is not performing as well as its peers (is up less than the market or other stocks in the sector), but a stock that is up less than its peers does not produce any tax benefits for the holder -- unless paying less tax on a smaller profit can be considered a benefit. So when investors talk about the tax benefits of underperforming stocks, they usually mean benefiting from a stock's loss.
Capital losses can offset gains in other investments, but only $3,000 in losses in excess of capital gains can be written off income tax in any year. The remaining losses must be carried over into the next tax year. A capital loss must be realized -- that is, an investor must sell a stock before he can claim a loss on his return.
Year-End Tax Loss Selling
Tax loss selling is the common practice of identifying losing ("underperforming") stocks and selling them before the year's end to generate losses to offset realized taxable gains in other stocks. Though widely used, this practice does not make much sense. Investors buy stocks to make money. If a stock is showing an unanticipated loss, it should be sold immediately to minimize the loss, not kept in the hope that it will "come back" or for year-end tax loss purposes.
Making the Best Out of a Bad Situation
If an investor is convinced that a losing ("underperforming") stock which he is holding has long-term potential, and especially if the stock has stopped declining or its decline has been moderate, he can sell the stock to generate a tax loss and buy it back. This involves a certain amount of risk. The Internal Revenue Service "wash sale" rule disallows any capital losses on a security if an investor buys a substantially identical security within 30 days of the sale. An investor selling a stock to generate a tax loss must wait 31 days before buying it back. The risk is that the stock price may advance during that time, forcing the investor to buy it back at a higher price, not buy it back and miss the potential upside or buy back in less than 31 days and lose the tax loss benefit.
Stock Investing Priorities
The most important and the most difficult thing in stock trading is to generate a profit. Using stock losses for tax benefits is a loser's game: it's always better to pay more tax on a higher profit than to console oneself with a tax loss benefit.
- Hand on stock page with chart drawn image by Allen Penton from Fotolia.com