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All About the Capital Loss Tax Deduction

When it comes to investing, you can expect to experience both gains and losses. You might even incur a capital loss on purpose to get rid of an investment that’s making your portfolio look bad. And while selling an asset at a loss may not seem ideal, it can benefit you at tax time. Besides lowering your taxable income, a capital loss may also help you snag a deduction.

Check out our capital gains tax calculator.

What Is a Capital Loss?

A capital loss occurs when you sell a capital asset for less than what you bought it for. Capital assets include stocks, bonds, homes and cars.

Any expenses from the sale of an asset count toward the loss amount. You may be able to claim a capital loss on an inherited property, too, if you sold it to someone who’s not related to you and neither you nor your family members used it for personal purposes.

It’s important to remember that capital losses (also known as realized losses) only count following a sale. So just having a stock decrease in value isn’t considered a capital loss even if you hold on to it. An asset that you keep after its price has fallen is called an unrealized loss.

Realized gains (or profits from the sale of an investment) should always be reported to the IRS using Form 8949 and Schedule D. You’ll also use Schedule D to deduct your capital losses. Realized losses from the sale of personal property, however, do not need to be reported to the federal government and usually aren’t eligible for the capital loss tax deduction.

The Capital Loss Tax Deduction

All About the Capital Loss Tax Deduction

The capital loss deduction gives you a tax break for claiming your realized losses. In other words, reporting your losses to the IRS can shrink your tax bill.

How much you can deduct depends on the size of your gains and losses. If you end up with a larger capital gain amount, you can subtract your losses from your gains. This lowers the amount of income that’s subject to the capital gains tax.

What happens if your losses exceed your gains? The IRS will let you deduct up to $3,000 of capital losses (or up to $1,500 if you and your spouse are filing separate tax returns). If you have any leftover losses, you can carry the amount forward and claim it on a future tax return.

Short-Term and Long-Term Capital Losses

Capital gains and losses fall into two categories: long-term gains and losses and short-term gains and losses. If you sell an investment you owned for a year or less, it’s considered a short-term gain (or loss). If you sell an asset you’ve held for over a year, it counts as a long-term loss or gain.

These classifications come into play when calculating net capital gain. In order to use your losses to offset your gains, you must first group them together by type. Short-term losses must initially be deducted from short-term gains before you can apply them to long-term gains (and vice versa). 

Short-term capital gains are taxed like ordinary income. That means your tax rate might be as high as 39.6%. And depending on your income, you might also owe a 3.8% Medicare surtax.

Tax rates for long-term capital gains, on the other hand, are generally much lower. If you’re in the 10% or 15% tax bracket, you won’t owe any taxes if you have long-term capital gains. If you’re in a higher tax bracket, you’ll face a 15% or 20% tax rate. But exceptions may apply. For example, gains from the sale of real estate related to depreciation may result in a 25% tax if you’re in the 25% income tax bracket or a higher tax bracket.

You may want to consider selling your assets at a loss when you have short-term capital gains (or no gains at all). That way, you’ll minimize your tax bite and eliminate low-performing investments at the same time.

The Wash-Sale Rule

All About the Capital Loss Tax Deduction

If you’re a savvy investor, you may be tempted to take advantage of tax loopholes. Some think they can sell a deflated stock and then immediately buy back the same stock or a similar security. That way, they can deduct a capital loss on their tax return while their portfolio remains relatively unchanged.

That may seem like a good plan. But if you put it into practice, you’ll be breaking the wash-sale rule. This rule says that if you sell a security at a loss, you can’t buy it back (or buy a stock that’s nearly identical to the one you sold) within the 30-day period before or after the sale. If you break the rule and get caught, you’ll have to add the loss to the cost of the new stock you purchased. 

To work around the wash-sale rule, you can sell shares of one company’s security and pick up the same type of fund from a different company. To avoid the wash-sale rule in bond trading, it’s best to make sure your new bond differs from the original bond in at least two ways. For example, your new bond may need to have a different rate, maturity or issuer.

The Takeaway

Selling an asset at a loss isn’t the worst thing in the world. In fact, some investors deliberately incur capital losses to lessen their capital gains tax bite. If you’re trying to use a capital loss to offset your gains, just remember to follow the rules so that you can qualify for a tax break.

Photo credit: ©iStock.com/peshkov, ©iStock.com/Tempura,

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Lauren Perez, CEPF® Lauren Perez writes on a variety of personal finance topics for SmartAsset, with a special expertise in savings, banking and credit cards. She is a Certified Educator in Personal Finance® (CEPF®) and a member of the Society for Advancing Business Editing and Writing. Lauren has a degree in English from the University of Rochester where she focused on Language, Media and Communications. She is originally from Los Angeles. While prone to the occasional shopping spree, Lauren has been aware of the importance of money management and savings since she was young. Lauren loves being able to make credit card and retirement account recommendations to friends and family based on the hours of research she completes at SmartAsset.
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