Capital Loss Taxation

While everyone hopes to earn money when they invest in the stock market, no investor ever makes money 100% of the time. However, dealing with a capital loss doesn’t need to mean that money went to waste. Depending on when you bought and sold your assets, you may be able to use capital losses to your advantage when it comes time to file your taxes. 

What is a Capital Loss?

Capital losses arise when an investment decreases in value from its original price. In other words, when you sell an asset for less than you bought it for, you’ll incur a capital loss. Capital losses can apply to stocks, real estate and many other types of assets. Understanding capital loss taxation rules can help you get the most when deducting these losses from your taxes. Any leftover capital losses are carried forward to future years.

Deducting Capital Losses From Your Tax Return

The main discussion around capital losses revolves around how to treat them on your individual tax return. The bottom line is that you first must use them to offset capital gains. If you have more losses to claim beyond your capital gains, on your IRS Form 1040 you may deduct capital losses up to $3,000 in remaining capital losses against other types of income. 

You cannot claim capital losses on any asset that you own. Cars and boats, for example, are considered to be personal use items by the IRS. Losses on personal use items are generally not tax-deductible. On the flip side, gains from personal use items are typically taxable. 

You don’t incur capital losses until you sell the asset you’re holding. For example, imagine that you purchase one share of Company A’s stock for $100, and the price of the stock falls to $95. If you sell the stock at a price of $95, you have incurred $5 in capital losses. If you hold onto the stock, you have not yet realized a capital loss because you haven’t sold the stock yet. You can only deduct losses on investments that are completely closed.

By following the proper steps, you may be able to mitigate your capital losses. First, offset capital losses against capital gains on your Form 1040. When you have a combination of short-term and long-term capital gains and losses, first subtract the short-term losses from short-term gains. Then, deduct the long-term losses from long-term gains. Afterward, net the resulting long-term number and short-term number. Your next steps will depend on whether you’ve suffered a capital loss or not. If the result is a capital gain, you report this gain on your return. However, additional tax laws must be applied if the outcome is a capital loss.

Offsetting Gains or Income

When capital losses exceed capital gains, up to $3,000 of these losses can be used to reduce other types of income reported on the return. If capital losses surpass capital gains by more than $3,000, remaining capital losses roll forward to future years. Each subsequent year, only $3,000 of your banked capital losses may be applied against other types of income besides capital gains. If capital gains arise in future years, you may offset them in full with carried-forward capital losses. 

For example, imagine that you’ve finished calculating your assets and have found that you’ve had a total of $40,000 worth of capital gains and $50,000 of capital losses. Imagine that you also have $10,000 in regular income. The capital losses offset the capital gains, leaving $10,000 of remaining capital losses. You can then use $3,000 of the capital losses to offset your ordinary income, leaving you with $7,000 of taxable income and $7,000 of capital losses to use in future years. 

Capital Gains Tips for Investors

You can implement these strategies and tips to manage tax liability for capital gains and make the best use of capital losses. 

Consider investment holding periods: Investments held for over one year are taxed at more favorable rates than investments you’ve held only in the short term. Capital gain tax rates only apply to long-term investments. On the other hand, short-term capital gains are taxed at the ordinary income rate. Capital gain tax rates are capped at 20%, while ordinary income tax rates go all the way up to 37%. The tax savings are substantial if you can hold off on a sale until you meet the one-year holding period. 

When selling a home, take care to qualify for the home sale exclusion: Taxpayers are eligible to exclude between $250,000 and $500,000 of gain from the sale of their home if they meet the requirements for the exclusion. Generally, you must use the home as your primary residence for at least two of the last five years. This tax break is called an Section 121 exclusion and is designed to help homeowners selling a personal residence. 

Use a tax-deferred retirement plan: IRAs and 401(k) plans allow you to defer paying tax until you withdraw the money from the account, typically after retirement. The tax savings may be considerable, as you are likely to fall in a lower tax bracket during retirement compared to working full time. Keep in mind when using this strategy that the money invested cannot be accessed before retirement without incurring penalties. 

Sell investments in years when income is low: You may fall under a lower tax bracket when you have a lower income. A life change like retirement or losing a job for a significant period of time can create an opportunity to sell investments and minimize tax liability. 

Consider opening a Roth IRA: If you’re a younger investor, you might want to consider a Roth IRA for your retirement savings. Unlike traditional IRAs, Roth IRAs do not require you to pay taxes on your retirement funds as long as you do not withdraw the funds before retirement. Essentially, this feature means that your investments can grow and increase in value tax-free. However, you will need to pay income tax on your contributions – which might be much more affordable when you’re working on building your career. 

Donate stock: If you donate stocks instead of cash, you are spared from paying capital gains tax on the stock donated. On top of that, you are typically granted a deduction equal to the stock's fair market value. To determine a stock’s fair market value, add together the average high value of the stock and the average low value and divide the number by 2. 

Of course, to donate stock, the charity you’re donating to must allow you to donate in this manner. Most charities accept stock donations and will provide instructions on how to transfer your assets. 

Invest in an opportunity zone: The Tax Cuts and Jobs Act (TCJA) introduced opportunity zone regulations. The state designates certain areas as opportunity zones to encourage the development of these communities. You are permitted to defer tax on capital gains invested in opportunity zones until later down the road when you sell the property. As with most tax breaks, particular requirements need to be fulfilled for preferential tax treatment, so evaluate these strategies on a case-by-case basis. 

Implement tax loss harvesting: By selling losing investments at the end of the year to generate capital losses to offset capital gains, you can recover at least a portion of your losses by reducing tax obligations. When implementing this strategy, watch out for wash sale rules, which disallow deductions for losses when the stock is repurchased within 30 days of sale. Many investors get around this issue by buying a stock in a similar sector to maintain their portfolio makeup while not falling subject to the wash sale limitations. 

How to Turn Around a Losing Investment

While it is disappointing to deal with capital losses, you can use them beneficially. Not all is lost because you made an investment that didn’t turn out as you hoped it would. By implementing the strategies discussed above, you can minimize the tax bill to Uncle Sam and make the most of your losses by lowering the amount of money that you’ll owe because of capital loss tax rules and regulations.  

Frequently Asked Questions