Stock Loss Taxation

A bear market is not a fun experience for most investors. When stocks across sectors are down and down big, investors become more prone to panic as emotions begin to build. When will the bottom set in? How much longer will the decline last? And of course, how much pain can be tolerated before capitulating to the urge to sell?

Different investors will answer these questions in different ways, but no one likes to lose money. Investment losses can be painful; however, there is some solace to be had in the rules regarding stock loss taxation. In down years, investors may be able to write off a certain percentage of the losses taken by their portfolios. Here’s how it works.

How Does Stock Loss Taxation Work?

A capital asset is basically anything of value that you own, including stocks and bonds but also houses, cars, artwork and even the furniture in your living room. If you sell your couch for more than you paid for it, you have a capital gain on the sale. The IRS expects these gains to be reported, but if you’ve held the asset a while, you’ll get a bit of a break.

Capital gains are taxed at a beneficial rate — long-term capital gains are taxed at 0%, 15% or 20% depending on the income of the taxpayer. Short-term capital gains are taxed at the level of an investor’s adjusted gross income for the year, which is less favorable than the long-term rate. Holding assets for durations measured in years is obviously ideal, but it does occasionally make sense to sell something less than a year after you bought it. This distinction between long- and short-term capital gains is important because capital loss tax writeoffs are calculated in the same manner.

To write off your stock losses on your annual tax return, you’ll need to separate the long-term and short-term losses, just as you would long-term and short-term gains. Assets bought and sold for a loss after less than a year will be considered a short-term capital loss, with a few exceptions (inheriting property). To determine your total taxable obligation, you’ll need to pair your gains and losses based on the length you’ve held each particular asset.

How to Determine Your Capital Losses

Like capital gains, capital losses are divided into short-term and long-term transactions. To determine what your total capital losses are, you pair your gains and losses based on the type of tax treatment they receive.

Short-term capital gains are taxed as ordinary income, which can be as low as 10% or as high as 37% depending on your modified adjusted gross income (MAGI). If you bought $10,000 worth of stock in March 2020 and sold it for $25,000 in August 2020, you’ll have a $15,000 gain taxed at your income level (between 10% and 37%). However, if you bought stock in March 2020 and sold for $25,000 in April 2021, you’d have a $15,000 gain taxed at the capital gains rate (15% for single filers with incomes between $40,400 and $445,850).

Consider if you have another set of stocks that didn’t make money — in fact, you lost on the trades. You can deduct these losses against your capital gains depending on the length of time you held the asset. If you have a short-term loss of $5,000, you won’t get to deduct that against a $10,000 long-term gain. Short-term gains and losses must be paired together, same as long-term gains and losses. 

How to Deduct Capital Losses

You’ll need IRS Form 8949 and Schedule D from Form 1040 to properly calculate your long- and short-term capital losses and gains. Each individual stock transaction will be tallied on Form 8949, and your total stock loss deduction will be calculated on the Schedule D part of Form 1040. The gains and losses will be separated based on long- or short-term status, but calculated together at the end of the form. Here’s an example:

Record all your various stock purchases and sales on Form 8949. Part I is for short-term transactions, and Part II is for long-term transactions. All your buys and sell will be reported here, which is why it's beneficial to use a broker with efficient tax documentation. An asset held for 3 days or 10 months will get the same short-term capital gain tax treatment, likewise for a year and a day or 50 years on the long-term side.

Take the total of your short-term capital gains and deduct short-term capital losses on Part I. If you have $10,000 in gains and $4,000 in losses, your net short-term capital gains income would be $6,000 and you’d be taxed at your ordinary income level.

Now add up the long-term gains and losses on Part II. Sales of assets held longer than one year will be reported here. Let’s say you made $20,000 on a long-term position and want to sell, but you also took a $25,000 loss on another long-term position. You sold both positions in the same tax year, resulting in a net long-term capital loss of $5,000.

Time for Schedule D — add your long- and short-term gains or losses together on this sheet to figure out your total tax obligation on your stocks. While you can’t write off one short-term loss with a long-term gain, you can add the total of these different sets of transactions together. In the example above, the result was $6,000 in short-term gains and $5,000 in short-term losses. The $5,000 in total capital losses would cancel the $5,000 in short-term capital gains, leaving $1,000 in short-term gains to be taxed at ordinary income level. 

What happens to stock taxation if losses exceed gains? In really bad years, investors might find themselves with a net loss on their capital transactions. In this scenario, capital losses can be deducted directly from income but only up to a certain limit. For single filers, $1,500 in total capital losses (short- and long-term combined) can be written off per year. Married couples get up to $3,000. So if you have a capital loss of $6,000 in 2021, you’ll only be able to deduct $3,000 from your 2021 taxable income. However, you can carry additional losses forward by using the Capital Loss Carryover Worksheet from Publication 550. In this situation, $3,000 in capital losses can be deducted in 2021, and the remaining $3,000 can be used in 2022.

Using Stock Losses to Your Advantage

No investor has a track record of 100% winners. But many choose to use their losers in advantageous ways. Tax-loss harvesting is a technique where losing stocks are paired with winners in order to lower a tax bill or keep income below a certain tax bracket. This method is one of the best ways to use stock loss taxation in your favor.

For example, imagine you have $15,000 in short-term capital gains to report which brings your total MAGI for the year to $180,000. The upper bound of the 24% tax bracket is $170,050, so the remaining $9,950 is taxed at 32%. In this scenario, you can take $9,950 in short-term losses to ensure none of your income is taxed at the higher 32% rate. Even if only $5,000 in short-term losses can be harvested, you’ll owe 32% on a sum of $4,950 instead of $9,950. No one like to lose money on investments, but at least the losses don’t have to simply fade into the ether of the markets.

Consider the Tax Treatment of Your Potential Capital Losses

Capital gains and losses should always be compared before filing your taxes. If you’re interested in learning more about tax planning and stock loss deductions, be sure to research Benzinga’s library of helpful articles.

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