Capital losses and capital gains are essential components in managing an investment portfolio, concepts that need to be well understood in order to begin investing in an informed and conscious manner. Understanding the mechanisms that determine them is crucial to making informed decisions and optimizing returns, both in financial and tax terms.
Through careful and knowledgeable management, investors can make the most of opportunities in the bond market while minimizing the risks and negative consequences of capital losses.
In this follow-up article we will better understand what capital gains (capital gains) and capital losses (capital losses) are and how to offset the different taxation based on the outcome of our investments.
1. What are capital gains and capital losses in the bond arena?
Bond capital gain is the gain realized when an investor sells a bond at a higher price than it was purchased. For example, if an investor buys a bond at 95 (value expressed as a percentage of par value) and then sells it at 100, the difference of 5 represents a capital gain.
Bond capital loss, on the other hand, is the loss incurred when an investor sells a bond for less than the purchase price. If, for example, the investor buys a bond at 100 and sells it at 90, the loss of 10 is a capital loss.
Let us give practical examples to better understand the concepts:
Case 1: Capital gain or capital gain
An investor buys a corporate bond at 980 euros and sells it at 1,020 euros. He realizes a capital gain of 40 euros. This amount will be subject to taxation, unless there are prior capital losses to be offset.
Case 2: Capital loss or capital loss
An investor buys a government bond at 1,000 euros and sells it at 950 euros. The loss of 50 euros is a capital loss that can be used to offset future capital gains within the set time limit.
Capital losses can be subtracted from capital gains, thus reducing the tax you have to pay on gains. In Italy, taxation on financial capital gains is generally 26 percent (or 12.5 percent for some government bonds). By offsetting capital losses, you can lower the tax base on which this rate is applied.
2. Determining factors of capital gains and capital losses.
Bond price fluctuations, and thus the possibility of generating capital gains or losses, are influenced by a combination of several factors:
Interest rates:
The price of bonds is inversely related to interest rates. When rates rise, the value of already issued bonds tends to fall, as they become less attractive than newly issued bonds with higher coupons. Conversely, a decline in interest rates increases the price of existing bonds, encouraging the realization of capital gains.
Issuer credit risk:
If the issuer’s perceived risk of default increases, the price of the bond decreases, generating potential capital losses for the seller. Conversely, a reduction in perceived risk can increase the value of the bond.
Duration and expiration:
Bonds with a longer duration are more sensitive to changes in interest rates. Therefore, market movements can have a greater impact on their price.
Market conditions:
The supply and demand for bonds in the secondary market influence their price. Macroeconomic events, monetary policy decisions, and investor sentiment are just some of the variables at play.
3. Taxation of capital gains and capital losses.
In many countries, including Italy, bond capital gains are taxed as income of a financial nature.
Tax rates
Capital gains are generally taxed at a flat rate (e.g., 26 percent in Italy, with some exceptions at 12.5 percent as mentioned earlier for some government bonds).
Capital losses can be used to offset future capital gains, reducing the tax due. This offset is usually allowed within a time period defined by tax law (in Italy, within 4 years).
Declaratory and administered regime
Investors can choose from different tax regimes:
Administered regime: The bank or financial intermediary directly calculates and pays taxes on capital gains.
Reporting regime: The investor must independently report capital gains and losses on his or her tax return.
4. The management of capital gains and losses
Investors can adopt strategies to optimize the management of capital gains and capital losses:
Harvesting of capital losses:
Selling bonds at a loss to generate capital losses to be used to offset future capital gains.
Portfolio monitoring:
Regularly analyze the bond portfolio to identify strategic selling opportunities.
Diversification:
Reduce the risk of severe capital losses by diversifying investments among different issuers, sectors and maturities.
Fiscal optimization:
Plan transactions according to the tax year to maximize tax benefits from offsetting capital gains and losses.
