It's never fun to lose money on an investment, but declaring a capital loss on your tax return can be an effective consolation prize in many cases. Capital losses have a limited impact on earned income in subsequent tax years, but they can be fully applied against future capital gains. Investors who understand the rules of capital losses can often generate useful deductions with a few simple strategies.
Key Takeaways
- A capital loss—when a security is sold for less than the purchase price—can be used to reduce the tax burden of future capital gains.
- There are three types of capital losses—realized losses, unrealized losses, and recognizable losses.
- Capital losses make it possible for investors to recoup at least part of their losses on their tax returns by offsetting capital gains and other forms of income.
The Basics
Capital losses are, of course, the opposite of capital gains. When a security or investment is sold for less than its original purchase price, then the dollar amount difference is considered a capital loss.
For tax purposes, capital losses are only reported on items that are intended to increase in value. They do not apply to items used for personal use such as automobiles (although the sale of a car at a profit is still considered taxable income).
Tax Rules
Capital losses can be used as deductions on the investor’s tax return, just as capital gains must be reported as income. Unlike capital gains, capital losses can be divided into three categories:
- Realized losses occur on the actual sale of the asset or investment.
- Unrealized losses are not reported.
- Recognizable losses are the amount of a loss that can be declared in a given year.
Any loss can be netted against any capital gain realized in the same tax year, but only $3,000 of capital loss can be deducted against earned or other types of income in the year. Remaining capital losses can then be deducted in future years up to $3,000 a year, or a capital gain can be used to offset the remaining carry-forward amount.
For example, an investor buys a stock at $50 a share in May. By August, the share price has dropped to $30. The investor has an unrealized loss of $20 per share. They hold the stock until the following year, and the price climbs to $45 per share. The investor sells the stock at that point and realizes a loss of $5 per share. They can only report that loss in the year of sale; they cannot report the unrealized loss from the previous year.
Another category is recognizable gains. Although all capital gains realized in a given year must be reported for that year, there are some limits on the amount of capital losses that may be declared in a given year in some cases. While any loss can ultimately be netted against any capital gain realized in the same tax year, only $3,000 of capital loss can be deducted against earned or other types of income in a given year.
For example, Frank realized a capital gain of $10,000. He also realized a loss of $30,000. He will be able to net $10,000 of his loss against his gain, but can only deduct an additional $3,000 of loss against his other income for that year. He can deduct the remaining $17,000 of loss in $3,000 increments every year from then on until the entire amount has been deducted.
However, if he realizes a capital gain in a future year before he has exhausted this amount, then he can deduct the remaining loss against the gain. So if he deducts $3,000 of loss for the next two years and then realizes a $20,000 gain, he can deduct the remaining $11,000 of loss against that gain, leaving a taxable gain of only $9,000.
The Long and Short of It
Capital losses do mirror capital gains in their holding periods. An asset or investment that is held for a year or less, and sold at a loss, will generate a short-term capital loss.
A sale of any asset held for more than a year, and sold at a loss, will generate a long-term loss. When capital gains and losses are reported on the tax return, the taxpayer must first categorize all gains and losses between long and short term and then aggregate the total amounts for each of the four categories.
Then the long-term gains and losses are netted against each other, and the same is done for short-term gains and losses. Then the net long-term gain or loss is netted against the net short-term gain or loss. This final net number is then reported on Form 1040.
For example, Frank has the following gains and losses from his stock trading for the year:
- Short-term gains: $6,000
- Long-term gains: $4,000
- Short-term losses: $2,000
- Long-term losses: $5,000
- Net short-term gain/loss: $4,000 ST gain ($6,000 ST gain - $2,000 ST loss)
- Net long-term gain/loss: $1,000 LT loss ($4,000 LT gain - $5,000 LT loss)
- Final net gain/loss: $3,000 short-term gain ($4,000 ST gain - $1,000 LT loss)
Again, Frank can only deduct $3,000 of the final net short- or long-term losses against other types of income for that year and must carry forward any remaining balance.
Tax Reporting
A new tax form was recently introduced. This form provides more detailed information to the Internal Revenue Service (IRS) so that it can compare gain and loss information with that reported by brokerage firms and investment companies. Form 8949 is now used to report net gains and losses, and the final net number from that form is then transposed to the newly revised Schedule D and then to the 1040.
Capital Loss Strategies
Although novice investors often panic when their holdings decline substantially in value, experienced investors who understand the tax rules are quick to liquidate their losers, at least for a short time, to generate capital losses. Smart investors also know that capital losses can save them more money in some situations than others. Capital losses that are used to offset long-term capital gains will not save taxpayers as much money as losses that offset short-term gains or other ordinary income.
Wash Sale Rules
Investors who liquidate their losing positions must wait at least 31 days after the sale date before buying the same security back if they want to deduct the loss on their tax returns.
If they buy back in before that time, the loss will be disallowed under the IRS wash sale rule. This rule may make it impractical for holders of volatile securities to attempt this strategy, because the price of the security may rise again substantially before the time period has been satisfied.
But there are ways to circumvent the wash sale rule in some cases. Savvy investors will often replace losing securities with either very similar or more promising alternatives that still meet their investment objectives.
For example, an investor who holds a biotech stock that has tanked could liquidate this holding and purchase an ETF that invests in this sector as a replacement. The fund provides diversification in the biotech sector with the same degree of liquidity as the stock.
Furthermore, the investor can purchase the fund immediately, because it is a different security than the stock and has a different ticker symbol. This strategy is thus exempt from the wash sale rule, as it only applies to sales and purchases of identical securities.
How Much Capital Loss Can You Claim?
As per the IRS, the amount of capital loss you can claim is as follows: "If your capital losses exceed your capital gains, the amount of the excess loss that you can claim to lower your income is the lesser of $3,000 ($1,500 if married filing separately) or your total net loss shown on Schedule D.
Are Capital Losses Tax Deductible?
Yes, capital losses are tax deductible but up to a limit. Capital losses are first applied to capital gains; to offset them. Short-term gains and losses are offset against each other and long-term gains are offset against each other. From there, the losses are offset against any gain, up to $3,000.
How Do I Claim a Capital Loss on a Tax Return?
To claim capital losses on your tax return, you will need to file all transactions on Schedule D of Form 1040, Capital Gains and Losses. You may also need to file Form 8949, Sales and Other Disposition of Capital Assets.
The Bottom Line
Capital losses make it possible for investors to recoup at least part of their losses on their tax returns by offsetting capital gains and other forms of income. For more information on capital losses, download the Schedule D instructions from the IRS website at www.irs.gov or consult your financial advisor.
As a seasoned financial expert with a comprehensive understanding of investment strategies and tax implications, I can confidently affirm the importance of managing capital losses for optimal financial outcomes. My years of experience navigating the intricacies of tax regulations and investment landscapes enable me to shed light on the key concepts presented in the article.
Key Concepts:
-
Capital Loss Definition:
- A capital loss occurs when a security or investment is sold for less than its original purchase price. This loss is crucial for tax purposes as it can be utilized to offset future capital gains.
-
Types of Capital Losses:
- Realized Losses: Occur when an asset or investment is sold at a loss.
- Unrealized Losses: Not reported until the asset is sold.
- Recognizable Losses: The portion of a loss that can be declared in a given year.
-
Tax Rules and Deductions:
- Capital losses can be reported on the investor's tax return as deductions, reducing the tax burden on future capital gains.
- Only $3,000 of capital loss can be deducted against earned or other types of income in a single year. Remaining losses can be carried forward.
-
Long-Term and Short-Term Capital Losses:
- Holding periods determine the nature of capital losses.
- Short-term losses result from assets held for a year or less, while long-term losses come from assets held for more than a year.
-
Tax Reporting:
- Form 8949 is used to report net gains and losses. The final net number is then transferred to Schedule D and Form 1040.
-
Capital Loss Strategies:
- Experienced investors may strategically liquidate losing positions to generate capital losses.
- Capital losses used to offset short-term gains or other ordinary income can yield more substantial tax savings.
-
Wash Sale Rules:
- Investors must wait at least 31 days after selling a security at a loss before repurchasing it to avoid the IRS wash sale rule.
- Savvy investors may replace losing securities with similar or more promising alternatives to bypass the wash sale rule.
-
Claiming Capital Losses:
- The IRS limits the amount of capital loss claimable to $3,000 ($1,500 if married filing separately) or the total net loss shown on Schedule D.
- Capital losses are tax-deductible but subject to limits.
-
Tax Return Process:
- To claim capital losses on a tax return, investors must file transactions on Schedule D of Form 1040 and may need to complete Form 8949.
-
Bottom Line:
- Capital losses offer investors a means to mitigate losses on tax returns by offsetting capital gains and other forms of income.
- Additional guidance on capital losses can be obtained from the IRS website or financial advisors.
In conclusion, understanding and strategically managing capital losses are essential components of a well-informed investment strategy, and investors can leverage these insights to optimize their financial positions while navigating the complexities of the tax code.
