Capital losses can indeed offset ordinary income, providing a potential tax advantage for investors. The Internal Revenue Service (IRS) allows investors to use capital losses to offset up to $3,000 in ordinary income per year. But to understand this concept fully, it’s crucial to explore what capital losses are, the distinction between short-term and long-term losses, as well as the rules surrounding capital losses.
Need help managing your capital gains and losses? Speak with a financial advisor today.
What Is a Capital Loss?
A capital loss occurs when you sell an investment like a stock, bond or real estate property for less than its cost basis, which is often the original purchase price. Capital losses are the opposite of capital gains, which happen when you sell an investment for a profit. These losses are typically incurred in the financial markets due to fluctuations in asset prices.
Capital losses can be categorized as short-term or long-term, depending on how long you held the asset before selling it. Short-term capital losses result from assets held for one year or less, while long-term capital losses stem from assets held for over one year.
Short-term losses initially can offset short-term gains – the profits made from selling assets held for one year or less. Conversely, long-term losses can first offset long-term gains. Then, net long and short gains or losses are netted against each other. However, you should take note that the tax treatment of short- and long-term losses may differ.
How Capital Losses Can Offset Ordinary Income
The IRS allows you to use capital losses to offset any capital gains you may have, which can reduce your overall tax liability. For example, say you made $8,000 in profits when you sold a stock that you held for over a year, but also took a $4,000 loss when you sold a different stock that you also owned for more than a year. The $4,000 capital loss would effectively reduce your $8,000 gain by half, leaving you to pay capital gains taxes on just a $4,000 gain.
What many taxpayers may not realize is that if your capital losses exceed your capital gains, you can use the remaining losses to offset ordinary income, such as your salary or business income. However, it’s essential to understand that there are limits to how much capital loss you can use to offset ordinary income.
For individuals, the maximum annual deduction for net capital losses against ordinary income is $3,000 ($1,500 if married and filing separately). If your losses exceed this limit, you can carry forward the remaining losses to future tax years, continuing to offset income until the losses are fully utilized.
For example, perhaps your total ordinary income for the year is $85,000, but you took a $5,000 capital loss on an investment that you sold and had no capital gains. The loss would lower your ordinary income for the year to $82,000 and leave you with $2,000 that you can deduct the following year.
How to Deduct Capital Losses
To deduct capital losses on your tax return, you must use Form 8949 and Schedule D. These forms help you report your capital gains and losses in detail. You’ll need to provide information about each investment sold, including the purchase and sale dates, the cost basis and the sale proceeds.
Form 8949 and Schedule D
Form 8949 is used to report the details of your capital asset transactions, both gains and losses. You’ll need to fill out this form for each transaction involving the sale of stocks, bonds, real estate or other investments. Each transaction’s information includes the date of sale, the description of the property, your purchase price and the sale price.
Part I of the form is where you’ll record your net short-term loss or gain, while Part II is used to record your net long-term loss or gain. You’ll then combine the two net totals to arrive at your total capital loss or gain.
After completing Form 8949, you’ll transfer the totals to Schedule D for IRS Form 1040, which provides an overview of your capital gains and losses. This form allows you to calculate the net capital gain or loss for the year. If your losses exceed your gains, you can use these losses to offset other income, potentially reducing your tax liability.
What Is the Wash Sale Rule?
Keep in mind that there are rules surrounding reinvesting in assets that you previously sold at a loss and claimed a deduction. The wash sale rule is a regulation that prevents taxpayers from claiming a loss on the sale of a security if they repurchase the same security or a “substantially identical” one within 30 days before or after the sale.
Violating this rule could result in the disallowance of the loss deduction. Investors should be aware of the wash sale rule when managing their portfolios.
However, the wash sale rule doesn’t mean you lose the benefit of the loss forever. The disallowed loss is carried forward and added to the cost basis of the replacement investment. This can reduce your capital gains tax liability when you eventually sell the replacement investment at a gain.
Bottom Line
Capital losses can be a valuable tool for reducing your tax liability, not just because they can offset capital gains, but because they can be used to reduce ordinary income. The IRS allows you to use capital losses to offset capital gains, plus up to $3,000 of ordinary income in a given year. If your losses exceed this limit, the leftover losses can be carried forward and used in future years. Understanding the distinction between short-term and long-term losses, how to report them on your tax return, and the implications of the wash sale rule are all essential for optimizing your tax strategy.
Tax Planning Tips
- If you want to get a headstart on filing your taxes this year, consider using SmartAsset’s tax return calculator first. The free tool can help you project how much you may owe or receive after filing your tax return.
- Some financial advisors are also tax experts who can help you optimize your tax 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 have a free introductory call with your advisor matches to decide which one you feel is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
Photo credit: ©iStock.com/Thapana Onphalai, ©iStock.com/small smiles, ©iStock.com/katleho Seisa