Part 2: The Essentials of Capital Losses and Tax Deductions
Key Insights
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.
Understanding Capital Losses and Tax Reporting
For example, an investor buys a stock at $50 per share in May. By August, the share price drops to $30, resulting in an unrealized loss of $20 per share. The investor holds onto the stock, and by the following year, the price climbs to $45 per share. The investor sells the stock, realizing a loss of $5 per share. This loss can only be reported in the year of the sale; the unrealized loss from the previous year cannot be reported.
Capital losses mirror capital gains in their holding periods. An asset held for a year or less and sold at a loss generates a short-term capital loss. Conversely, a sale of an asset held for more than a year at a loss results in a long-term capital loss. When reporting capital gains and losses on a tax return, the taxpayer must categorize all gains and losses as long-term or short-term and aggregate the totals for each category. Long-term gains and losses are netted against each other, as are short-term gains and losses. The final net number is then reported on Form 1040.
Tax Reporting
A new tax form, Form 8949, has been introduced to provide the IRS with more detailed information, allowing for better comparison with reports from brokerage firms and investment companies. Net gains and losses are first reported on Form 8949, and the final net number is transposed to the newly revised Schedule D before being included on Form 1040.
Capital Loss Strategies
Experienced investors that understand the tax rules may liquidate their losing investments to generate capital losses strategically. These losses can be more beneficial when offsetting short-term gains or ordinary income rather than long-term gains. Novice investors often panic during substantial value declines, but knowledgeable investors use these opportunities to their advantage. A few examples are as follows:
1. Tax-Loss Harvesting
Timing of Sales: Sell investments that have declined in value to realize losses and use those losses to offset gains from other investments.
Reinvestment: Reinvest the proceeds from the sale into similar but not identical investments to avoid the wash-sale rule.
2. Offsetting Gains
Short-Term vs. Long-Term: Use capital losses to offset capital gains, prioritizing short-term gains first because they are taxed at a higher rate than long-term gains.
3. Carryover Losses
Future Use: If your capital losses exceed your capital gains in a given year, you can carry over the excess loss to offset gains in future years.
4. Tax-Deferred Accounts
Roth Conversions: Use losses to offset gains when converting traditional IRA accounts to Roth IRAs, reducing the tax burden of the conversion.
As with any tax-related information and decision-making, please refer to your financial advisor or tax specialist. The above is only an explanation of possible options.
Claiming Capital Losses
According to the IRS, if your capital losses exceed your capital gains, you can claim the lesser of $3,000 ($1,500 if married filing separately) or your total net loss shown on Schedule D to lower your income. Capital losses are tax-deductible, up to this limit. They are first applied to offset capital gains, and any remaining losses can offset up to $3,000 of other income.
To claim capital losses on your tax return, file all transactions on Schedule D of Form 1040, Capital Gains and Losses, and possibly Form 8949, Sales and Other Disposition of Capital Assets.
Final Thoughts
Capital losses allow investors to recoup part of their losses on their tax returns by offsetting gains and other income. For more detailed information, consult the Schedule D instructions on the IRS website or speak with your financial advisor.
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