As 2012 draws to a close, we are faced with much uncertainty about potential tax rate increases, the “fiscal cliff,” and much of the confrontation taking place on Capitol Hill. Whether we are going to step over the “fiscal cliff” or Congress finds a solution to avert it, we can all be sure of one thing: certain tax increases, tax cut expirations, or a combination of both are inevitable (e.g. 3.8% Medicare tax on investment income). That said, there remains uncertainty as to which tax rates will be raised and to what extent. For example, long term capital gain rates presently stand at 15% and are slated to increase. However, the possibility exists that Congressional compromises could keep them low. As such, we are in a situation where we need to rethink our year-end tax planning strategies and maybe reverse some of the more traditional action steps.

As a year-end strategy, taxpayers usually try to defer the recognition of income and/or gains to any extent possible. However, due to the scheduled increase in tax rates, 2012 is the year in which we may want to accelerate income and gain recognition and defer recognition of losses and deductions. How should we go about achieving this? Why not, for once, use to our advantage some of the same tax rules that were designed to defer loss recognition and accelerate gain recognition in the first place?

For example, let’s look at wash sales and how we can use wash sales without changing our economic position in a certain security. The simplest way is to intentionally trigger wash sales to our advantage. Portfolio holdings which are in an unrealized depreciation position can be sold and immediately repurchased (or repurchased within 30 days). By operation of law, the wash sales rules would be triggered,and such realized losses disallowed for tax purposes in 2012. Said losses would be available in subsequent years as a potential offset against future capital gains that are scheduled to be taxed at a higher rate. In addition, a taxpayer can sell a security at a loss and subsequently purchase a call option in that same security. At the time the taxpayer enters into an option to purchase the same (or “substantially identical”) security, the wash sales rules would be triggered and the loss realized on the sale of the security would be deferred and the cost basis of the option adjusted to reflect the disallowed loss. Subsequently, the taxpayer can repurchase the same security on the open market and a wash sale loss deferral would not be triggered again since the loss on the initial sale of the security was deferred at the time the option was purchased and “attached” to the cost basis of such option. The option can be sold after thirty-one days from the second purchase of the security (to avoid triggering a second wash sale) and the initial loss would be “released," with the result that the taxpayer is in the same economic position on the security as before the first sale. The unrealized loss in the security is being “transferred” to the option and subsequently realized without having to be “out” of the security itself for thirty-one days.

Let’s assume that we are unsure as to whether or not tax rates will increase in 2013 but we want the option to either preserve our capital losses and utilize them in 2013 or to recognize them in 2012. A taxpayer can sell a security at a loss in December 2012 and realize a taxable loss. Under the wash sale rules, the taxpayer has until January 31, 2013 to “wash” those losses and create a deferral. Assuming by the end of January 2013 we have a clearer picture of what the rates will look like in 2013, we have the option to “wash” those losses realized in December by repurchasing the securities within thirty days of year-end (the assumed strategy if rates increase) or recognize those losses in 2012 (assuming rates stay the same).

Using a similar strategy, a taxpayer can gain some limited control over the year in which capital gains will be recognized by using the constructive sale rules to his advantage. For example, a taxpayer can enter into a “constructive” sale in December 2012 by opening a short position in the same security in which he already holds an appreciated long position. Under the constructive sale rules, the unrealized gain (but not loss) on the long position at the time the short position is opened must be realized in 2012 as if the taxpayer had disposed of the appreciated long position and recognized a gain. However, under a “short-term hedging” exception to the constructive sale rules, the taxpayer has the option to “cure” out of the constructive sale rule’s gain acceleration provisions by closing out the short position that created the constructive sale within thirty days after year-end. As mentioned above, assuming there will be more certainty available in January as to what 2013 capital gain rates will ultimately be, the taxpayer has the option to choose the year in which to recognize the capital gains generated in this strategy.

These are just a few examples of tax planning techniques that afford some limited control as to the year in which capital gains and losses can be recognized for tax purposes. Whatever the outcome of the current income tax debate, we hope that through proper planning certain negative effects can be mitigated.