Capital Losses and Tax

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Capital Losses and Tax

Losing money on an investment is never nice, but claiming a capital loss on your tax return may be an effective consolation reward in certain instances. Capital losses have little effect on earned income in following tax years, but they may be entirely offset by future capital gains. With a few easy tactics, investors who grasp the principles of capital losses may often create meaningful deductions.

Key Takeaways

  • When a security is sold for less than its acquisition price, a capital loss may be used to offset the tax on future capital gains.
  • Realized losses, unrealized losses, and recognized losses are the three forms of capital losses.
  • By balancing capital gains and other sources of income, investors may reclaim at least a portion of their losses on their tax returns.

The Basics

Capital losses, of course, are the inverse of capital gains. When a security or investment is sold for less than its initial purchase price, the difference in dollars is referred to as a capital loss.

Capital losses are only recorded for tax reasons on goods that are expected to rise in value. They do not apply to personal things such as vehicles (although the sale of a car at a profit is still considered taxable income).

Tax Rules

Capital losses may be deducted from an investor’s tax return in the same way that capital gains must be declared as income. Capital losses, unlike capital gains, may be classified into three types:

  1. Realized losses occur when an asset or investment is sold.
  2. Losses that have not yet been realized are not recorded.
  3. The amount of a loss that may be stated in a particular year is referred to as recognizable losses.

Any loss may be offset against any capital gain generated in the same tax year, but only $3,000 can be deducted against earned or other forms of income in the year. Remaining capital losses, up to $3,000 per year, may then be deducted in future years, or a capital gain can be utilized to offset the remaining carry-forward amount.

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In May, for example, an investor purchases a stock for $50 per share. The share price had fallen to $30 by August. The investor has a $20 unrealized loss per share. They keep the stock until the following year, when it rises to $45 a share. At that moment, the investor sells the stock for a $5 loss per share. They may only record that loss in the year of sale; they cannot declare the prior year’s unrealized loss.

Another category is observable gains. Although all capital gains earned in a given year must be reported for that year, there are certain restrictions in some situations on the amount of capital losses that may be declared in a particular year. While any loss may eventually be offset by any capital gain achieved in the same tax year, only $3,000 of capital loss can be deducted against earned or other forms of income in any particular year.

In 2013, for example, Frank earned a $10,000 capital gain. He also suffered a $30,000 loss. He may net $10,000 of his loss against his gain, but he can only deduct $3,000 of his loss against his other income for the year. From then on, he may deduct the remaining $17,000 in $3,000 increments until the total amount is removed.

However, if he realizes a capital gain in a subsequent year before exhausting this amount, he may deduct the remaining loss from the gain. So, if he deducts $3,000 in losses during the following two years and then realizes a $20,000 gain, he may deduct the remaining $11,000 in losses against the gain, resulting in a taxable gain of just $9,000.

The Long and Short of It

In their holding periods, capital losses do parallel capital gains. A short-term capital loss occurs when an asset or investment is kept for a year or less and then sold at a loss.

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Any asset owned for more than a year and sold at a loss will result in a long-term loss. When reporting capital gains and losses on a tax return, the taxpayer must first divide all profits and losses into long and short term categories, and then aggregate the total amounts for each of the four categories.

The long-term profits and losses are then tallied against each other, as are the short-term gains and losses. The net long-term gain or loss is then subtracted from the net short-term gain or loss. This net amount is subsequently reported on Form 1040.

For example, Frank’s stock trading profits and losses for the year are as follows:

  • Short-term gains: $6,000
  • Long-term gains: $4,000
  • Short-term losses: $2,000
  • Long-term losses: $5,000
  • Short-term net gain/loss: $4,000 ($6,000 ST gain – $2,000 ST loss)
  • Long-term net gain/loss: $1,000 ($4,000 LT gain – $5,000 LT loss)
  • Final net gain/loss: $3,000 in short-term gain ($4,000 in ST gain – $1,000 in long-term loss).

Again, Frank may only deduct $3,000 of his total net short- or long-term losses from other forms of income for that year, and any leftover balance must be carried forward.

Tax Reporting

Recently, a new tax form was launched. This form provides the Internal Revenue Service (IRS) with more precise information so that it may compare gain and loss information with that supplied by brokerage businesses and investment firms. The newly updated Schedule D is now used to record net profits and losses, and the final net figure from that form is subsequently transferred to the 1040.

Capital Loss Strategies

Although beginner investors often panic when the value of their assets drops significantly, professional investors who understand the tax regulations are fast to sell their losers, at least temporarily, in order to produce capital losses. Smart investors also understand that capital losses might save them more money in certain cases than others. Capital losses offset by long-term capital gains do not save taxpayers as much as losses offset by short-term capital profits or other regular income.

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Wash Sale Rules

If investors who liquidate their losing holdings wish to deduct the loss on their tax returns, they must wait at least 31 days following the selling date before purchasing the identical asset again.

If they purchase back in before that period, the IRS wash sale rule will prohibit the loss. This restriction may make it impossible for holders of volatile stocks to use this technique since the security’s price may climb significantly before the time limit is met.

However, there are several methods to get around the wash sale regulation. Savvy investors will often replace lost stocks with very comparable or more attractive alternatives that nonetheless match their investing goals.

For example, an investor who owns a biotech company that has fallen in value might sell it and replace it with an ETF that invests in the industry. The fund offers biotech diversity with the same level of liquidity as the stock.

Furthermore, since the fund is a distinct security than the stock and has a different ticker symbol, the investor may buy it right away. As the wash sale rule only applies to sales and acquisitions of identical securities, this technique is free from it.

The Bottom Line

By balancing capital gains and other sources of income, investors may reclaim at least a portion of their losses on their tax returns. For additional information on capital losses, visit the IRS website at www.irs.gov and obtain the Schedule D instructions, or contact your financial adviser.

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