Excess Capital Losses

According to Sec. 4940(a), a tax-exempt private foundation must pay a 2% excise tax on its net investment income, for the tax year. Its net investment income, under Sec. 4940(c)(1) and (3), is gross investment income and capital-gain net income (if any) less deductions for ordinary and necessary expenses it paid or incurred in connection with producing the gross investment income.

Under Sec. 4940(c)(4)(A), capital-gain net income takes into account property used for the production of income and only gains and losses from the sale or other disposition of property used to produce interest, dividends, rents or royalties. If disposing of such property results in a capital loss, the foundation can subtract the loss only from capital gains, under Regs. Sec. 53.4940-1(f)(3). It cannot deduct any excess capital loss from gross investment income in any tax year, nor can it use such loss to reduce gains in either prior or future tax years. Thus, Sec. 4940(c)(4)(C) provides that capital losses from sales or other dispositions of property are allowed, but only to the extent of capital gains, without carryovers.

As an alternative, the foundation can sell an unrealized capital-gain asset and immediately repurchase it. Of course, in so doing, it should not incur a transaction cost in excess of its excise tax rate (e.g., 1% or 2%). In using this advantageous strategy, the private foundation (1) does not needlessly forgo the capital loss, because the loss offset the capital gain; (2) does not pay the 2% excise tax on the recognized capital gain (which it might have to pay if the asset were sold in a year when no capital losses are available); and (3) now has an increased tax basis in the asset sold and repurchased (which will decrease future recognizable capital gain).

Example: On March 11, 2003, private foundation P sold T Corp. stock and recognized a $10,000 capital loss for the tax year ending Dec. 31, 2003. It also has an unrealized $10,000 capital gain in 50 shares of Z Corp. stock. In lieu of simply forgoing the $10,000 T stock capital loss at the end of 2003, P sells its 50 shares of Z stock on Dec. 31, 2003 and immediately repurchases 50 Z shares.

In the example, P (1) used the $10,000 capital loss that it could not use to reduce gain in either prior or future tax years; (2) did not have to pay the excise tax from the Z stock sale, because the T stock $10,000 capital loss reduced the gain on Z to zero; and (3) put itself in a better position with the repurchased 50 Z shares, because that increased its basis in those shares to $10,000, without incurring excise tax. Additionally, the increased basis will reduce Ps future Z stock capital gain.

Finally, the Sec. 1091 wash-sales rules do not apply to the sale and repurchase of stock or securities if the position is sold at a gain.

From Christine M. DeRosa, J.D., MST, CPA, Washington, DC