You may be familiar with the tax implications of capital gains, but what about capital loss? A capital loss refers to the money that your investments lose. You can write off your capital losses from your taxes and do it year after year by using what’s known as capital loss carryover. This way you only have to use the portion of the loss every year that helps you with your taxes. Consider working with a financial advisor if you’re looking for more tax planning strategies for your specific situation.
What Is Capital Loss Carryover?
Capital loss carryover is the ability to use the capital loss tax deduction over multiple years if the loss is large enough. This means you can use the capital loss to offset taxable income. The IRS caps your claim of excess loss at the lesser of $3,000 or your total net loss ($1,500 if you are married and filing separately).
Capital loss carryover comes in when your total exceeds that $3,000, letting you pass it on to future years’ taxes. There’s no limit to the amount you can carry over. You simply carry over the capital loss until it’s gone.
If you want to read it for yourself, IRS Topic No. 409 lays out what you need to know about capital loss carryover. It also includes links to worksheets you can use to determine the amount you can carry forward.
How to Deduct Capital Losses on Your Taxes
Here are the two main ways to deduct capital losses from your taxes.
Deduct From Capital Gains
When you pay taxes you calculate both your long- and your short-term capital gains. Long-term capital gains are all the profits you made by selling assets held for more than one year and are taxed at the lower capital gains tax rate. Short-term capital gains are all the profits you made by selling assets you held for less than one year. These are taxed as ordinary income.
Then, you calculate your capital losses, in the same way, determining both long-term and short-term losses on the same basis.
Your capital losses offset same-category capital gains first. This means that long-term losses first offset long any term gains and short-term losses first offset short-term gains. Once your losses exceed your gain, you can carry that category’s losses over to the other.
For example, say you had the following trade profile in a year:
- Long-term gains: $1,000
- Long-term losses: $500
- Short-term gains: $250
- Short-term losses: $400
First, you deduct your long-term losses from your long-term gains, leaving you with taxable long-term capital gains of $500 for the year ($1,000 – $500). The next thing to do is to deduct your short-term losses from your short-term gains. Since your short-term losses are greater than your short-term gains, this leaves you with zero taxable short-term capital gains ($250 gains – $400 losses).
You now carry over excess losses from one category to the next. In this case, your short-term losses exceeded your short-term gains by $150. So you reduce your remaining long-term gains by that amount, leaving you with taxable long-term capital gains of $350 for the year ($500 long-term gains after losses – $150 excess short-term losses).
Deduct Excess Losses From Income
Capital losses can apply to ordinary income taxes – to a limited extent. Say you have a very bad year in the market. You sell stocks for a total gain of $10,000, but sell other stocks for a total loss of $15,000. You could deduct the first $10,000 of those losses from your capital gains, leaving you with no taxable capital gains for the year. This would leave you with an excess capital loss of $5,000.
You can claim $3,000 of those losses as deductions on your ordinary income taxes for the year. Then, the following year, you can claim the remaining $2,000 as a carried-forward deduction on that year’s income taxes.
What Is Tax Loss Harvesting?
Tax loss harvesting is a strategic method used to offset capital gains with capital losses. Basically, if an investor expects a windfall from the sale of one asset, they’ll also sell an underperforming asset at a loss to get the capital loss tax deduction. The investor is communicating to the IRS that, yes, they had a large gain, but they also had losses and should be taxed less.
Typically investors using tax loss harvesting wait until the end of the year so they can be sure of potential losses. Meanwhile, once they’ve sold the assets at a loss, they’ll buy up similar assets to stay invested in that space and maintain asset allocation. If you’re considering tax loss harvesting, just keep in mind the wash-sale rule so you don’t get in trouble with the IRS.
What Is the Wash Sale Rule?
The wash sale rule is a rule put in place by the IRS to discourage investors from using tax breaks unfairly. Essentially, it prevents investors from selling an asset at a loss and buying that asset again. The wash sale rule says that investors need to have a minimum of 30 days before or after a sale of a loss to re-purchase assets that they sold at a loss.
The rule also prevents you from purchasing “substantially identical” assets in less than 30 days. Unfortunately, the IRS does not concretely define what “substantially identical” means. On Page 56 of Publication 550, they say, “In determining whether stock or securities are substantially identical, you must consider all the facts and circumstances in your particular case.”
It’s safe to say that the same stock from the same company is substantially identical. However, it’s a lot more complicated if you’re talking about buying and selling mutual funds. It depends on the manager, the securities in the fund and what index they follow.
One way investors get around the wash sale rule is to trade stock in for an ETF. For example, if you sell Meta stock at a loss to take advantage of the capital loss carryover, you can then buy a tech ETF that contains Meta. Because they’re not the same type of security, you won’t be committing a wash sale and you can still keep your assets in the tech sector.
The capital loss carryover is a great resource you can use. It allows for up to $3,000 to be the maximum capital loss allowed to be taken each year, until the total capital loss has been deducted. You can use it as a tool to offset capital gains you’ve received. If you want to be strategic, you can also employ tax loss harvesting to make the most of the tax break. If you feel overwhelmed, turning to a qualified financial advisor can help decide what to do with your money.
Tips for Investing
- You’re likely to incur losses at some point while investing and when you do it’s important that you make the most of them. A financial advisor can help you manage your investments or to create a long-term investment plan. Finding a financial advisor doesn’t have to be hard. SmartAsset’s free tool matches 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 you achieve your financial goals, get started now.
- Having the right balance of assets is essential to have a diverse and secure portfolio. SmartAsset’s Asset Allocation Calculator can help you determine where you should put your money depending on your risk profile.
Photo credit: ©iStock.com/PrathanChorruangsak, ©iStock.com/Vladimir Vladimirov, ©iStock.com/FG Trade Latin