Even the savviest investors pick assets that turn out to be duds. But fortunately, your capital losses can become tax deductions. While you don’t have to sell an asset whose value has nosedived, ridding your portfolio of dead weight can help you at tax time. In addition, federal tax law requires you to report capital losses when filing. Here’s how to comply with IRS regulations for capital losses and ensure you reap a tax benefit.
A financial advisor can help optimize your financial plan to lower your tax liability.
What Are Capital Losses?
A capital loss occurs when your asset’s value drops beneath the price for which you purchased it. Then, if you sell the asset, you ‘realize’ the loss, which has tax implications.
On the other hand, continuing to hold the asset has no consequences for taxes. So, you get reportable capital losses only by trading assets that have declined in value instead of merely owning them.
For example, you purchase ten shares of a company’s stock at $100 per share. You hold onto the stock for a year, at which time they decrease to $40 per share. If you sell the shares, you realize a $600 capital loss ($1,000 minus $400 equals $600).
Do You Have to Report Capital Losses?
If you experienced capital gains or losses, you must report them using Form 8949 when you file taxes. Selling an asset, even at a loss, has crucial tax implications, so the IRS requires you to report it. You’ll receive information about your investments from your broker or bank on Forms 1099-B or 1099-S. These forms will help you accurately report your investment activity.
How to Report Capital Losses
After receiving the 1099 Forms from your financial institutions, you’ll transfer the information to Form 8949. This is a worksheet where you list your short-term and long-term gains and losses.
Short-term losses come from assets you sell after owning them for a year or less, while long-term losses come from assets you have owned for more than a year. Together, these losses combine to form your net loss. Once you complete Form 8949, you’ll state your net loss using Schedule D on Form 1040.
How Capital Losses Can Offset Income
Your capital losses can reduce income taxes when you file. For instance, let’s say you sell three assets. The first two assets create a capital loss of $10,000. You sell the last asset for a gain of $4,000. As a result, your investment activity incurs a capital loss of $6,000.
IRS regulations let you use net capital losses to offset income when you file. Specifically, you can use $3,000 of capital losses per year to lower income taxes ($1,500 if you’re married filing separately). So, using the above example, you can reduce your income by $3,000 using your capital losses.
Fortunately you can carry over surplus capital losses to next year’s taxes. Therefore, since you have $6,000 of losses, you can allocate $3,000 this year and another $3,000 next year.
Capital Loss Guidelines
Capital losses have critical tax ramifications. Remember these four things to help make the most of this tax strategy:
- Your capital gains and losses will always combine to create a net gain or loss. In other words, you’ll subtract your capital losses from your gains, no matter how high or low either figure is. For example, $101,000 of capital losses and $100,000 of capital gains result in a $1,000 net loss.
- While your capital losses might be in the thousands, you can only use $3,000 to mitigate your income taxes. And remember, that number is cut to $1,500 for those married filing separately.
- Although you have a $3,000 limit for applying capital losses, you can carry them over to future tax years forever. In other words, carryover capital losses never expire for tax purposes.
- Similarly, capital losses carry over forever when calculating net gain or loss. As a result, a huge capital loss last year can offset massive gains this year. For example, say you had $20,000 of losses last year. You allocated the full $3,000 for taxes, leaving you with $17,000 of carryover losses. This year, you experience $15,000 of capital gains. Using your carryover losses leaves you with a net capital loss of $2,000, which you can use to reduce taxes.
Bottom Line
The IRS requires filers to report capital losses, even though capital losses on their own don’t equate to owing taxes to the government. That said, capital losses have two primary tax implications: first, they combine with capital gains for the year to create a net loss or gain. Second, if they create a net loss, you can use it to lower your taxable income by $3,000.
Remember, capital losses above this threshold can apply to future years’ income taxes. Therefore, reporting capital losses is necessary to comply with federal tax law and typically produces tax benefits.
Tips for Reporting Capital Losses
- When trading assets, you introduce another layer of complexity to your taxes.Afinancial advisorcan help you optimize your financial plan to lower your tax liability.SmartAsset’s free toolmatches you with up to three vetted financial advisors who serve your area, and you can interview your advisor matches at no cost to decide which one is right for you. If you’re ready to find an advisor who can help streamline your finances,get started now.
- Use ourcapital gains tax calculatorto see how your investments will impact your taxes.
- Capital losses are excellent for maximizing tax deductions. Use our guide for more about using capital losses correctly for taxes.
Photo credit: ©iStock.com/Moyo Studio,©iStock.com/AaronAmat,©iStock.com/tommaso79
As a financial expert with a deep understanding of tax regulations and investment strategies, I want to emphasize the importance of managing capital losses effectively to optimize your tax benefits. My extensive experience in the field allows me to shed light on the concepts discussed in the article.
Firstly, the article introduces the concept of capital losses, emphasizing that they occur when the value of an asset drops below its purchase price. This decrease in value becomes a realized loss when you sell the asset, and these losses have tax implications. It's crucial to note that simply holding onto a depreciated asset does not trigger tax consequences; the tax implications arise when you sell the asset at a loss.
The article rightly points out that reporting capital losses is a mandatory requirement according to federal tax law. Form 8949 is highlighted as the key document for reporting capital gains and losses when filing taxes. Financial institutions provide the necessary information through Forms 1099-B or 1099-S, aiding in accurately reporting investment activities.
To report capital losses effectively, the article guides readers on transferring information from the 1099 Forms to Form 8949. This worksheet is used to list both short-term and long-term gains and losses. The differentiation between short-term and long-term losses is explained, with the former arising from assets held for a year or less and the latter from assets held for more than a year.
The article further details how these losses combine to form a net loss, which is then reported on Schedule D of Form 1040. This step is crucial in complying with IRS regulations and ensuring that you maximize your tax benefits.
One of the key insights provided is how capital losses can offset income when filing taxes. The IRS allows individuals to use up to $3,000 of capital losses per year (or $1,500 if married filing separately) to lower their income taxes. Additionally, any surplus losses can be carried over to subsequent tax years, providing a valuable strategy for long-term tax planning.
The article concludes by summarizing important guidelines for dealing with capital losses, including the perpetual nature of carryover losses and the fact that capital losses, even though they may be higher, can only be used to mitigate up to $3,000 of income taxes per year.
In essence, the article serves as a comprehensive guide for investors to navigate the complexities of capital losses, from understanding the reporting requirements to utilizing these losses as a strategic tool for minimizing tax liabilities. If you're looking to optimize your financial plan in this regard, consulting with a financial advisor is recommended, as mentioned in the article.
