If handled right, selling a losing stock can be a winning move for your taxes

With a sharp downturn in October, the S&P 500 Index of U.S. stocks nearly reached a second 10 percent correction this year.

The index held a positive return for the year through October, but dozens of stocks in the index were down more than 10 percent year to date.

The declines mean that, more so than in the past several years, people who own investments outside of retirement accounts might be able to utilize a tactic to increase tax efficiency by selling investments that have declined in value.

The technical term is tax-loss harvesting. This does not apply to IRAs, 401ks or other retirement accounts where capital gains are not taxed. But in brokerage accounts where capital gains taxes apply, it’s possible to realize capital losses to offset capital gains and possibly even ordinary income, improving your tax situation.

This doesn’t apply only to individual stocks.

Depending on the timing of your purchases of mutual funds or exchange-traded funds of stocks or bonds, you might be able to sell a position that has declined. While this is a more recent development for U.S. stocks, it more broadly affects international stock investments, particularly emerging markets funds, which have declined more over the past year.

To evaluate your options, you need to review the cost basis of the holding compared to its current value. If the current value is lower than the total purchase cost, then you have an unrealized capital loss.

By selling the investment and realizing the loss, when you file your income taxes for 2018, you have two options to reduce tax.

You can pair losses against capital gains elsewhere in your account. The losses can directly offset the gains, meaning you won’t owe capital gains tax (15 percent for most people but more for high earners).

If your losses exceed your realized capital gains, then you can use the capital loss against your ordinary income, reducing it by up to $3,000 and carrying over any excess to future tax years. This could be larger tax savings. If you have an effective tax rate of 20 percent and you utilize losses to reduce your income by $3,000, this tactic saves you $600.

While the possibility of reduced taxation can make a negative return less upsetting, executing this tactic can be difficult. Investing is more than a numbers game. It is a psychological endeavor involving many behavioral biases that no one is immune to.

To sell an investment that has declined in value, you have to overcome human tendencies of loss aversion and the sunk cost fallacy. Many people hold out hope that an investment that is currently down will recover. They are averse to realizing a loss because it feels as if they admit to having made a bad decision.

Look at the opportunity to harvest the tax loss as a liquidity event that allows you the freedom to rebalance your investment accounts or shift to a more compelling investment, perhaps with lower costs and better future return prospects.

To understand whether there are more compelling options than holding on and hoping for a bounce back, think about the math of losses and gains needed to recover.

If you have a $1,000 investment and it declines 10 percent to $900, you now need an 11 percent increase from the new lower value to get back to original basis. Recently, many stocks have had larger declines. If an investment drops 25 percent, it then has to gain 33 percent from the new lower value to get back to even.

Is it likely to recover? More likely than another investment?

Don’t be afraid to cut losses short. There is no guarantee the next move is back up to even or better. It might continue to fall.

With anything tax related, there are pesky rules.

To utilize a tax loss, you can’t have bought new shares of the same — or even a “substantially identical” — investment you sold at a loss within 30 days before or after the sale at a loss. This would be considered a wash sale and realizing the loss on your tax return will be disallowed.

This applies even if you sell in one account but make the purchase in a different account. It also applies if you have automatically reinvested dividends, income and capital gains distributions.

Also understand that you don’t have to sell an entire investment. If you’ve added shares over time and only the most recent purchases have experienced losses, you can sell those specific shares. This requires more coordination with your account custodian to report the cost basis method of your investments.

It’s all a minor headache to sort out but can at least improve your after-tax returns.