Capital gains and capital losses both have tax implications. When you sell stocks for a profit, you owe taxes on those gains. These taxes are calculated based on capital gains rates. However, when it comes to investments, the IRS taxes you based on your net gains for the entire year. This means that you calculate your taxes based on the total amount of profits you made after accounting for any investment losses you took during the year. You can simplify this process if you work with a financial advisor who specializes in tax planning.
How the IRS Defines Capital Gains
Capital gains are the money that you make when you sell an investment for a profit. There are three key elements here to understand. First, the capital gains are calculated as profits rather than net gains. For example, when you sell a stock your capital gains on that stock sale are calculated as the sale price of the stock minus the price you paid for the stock.
So, say you buy 10 shares of stock at $50 per share. You would pay $500 for this stock purchase.
Then, say you sell those 10 shares of stock at $60 per share. You would net $600 for this stock sale. You would profit $100 from this stock sale (the sale price of $600 less the purchase price of $500). This $100 profit is the taxable capital gain.
Second, capital gains have to be realized in order to be taxed. For tax purposes, a capital gain is realized when you complete the sale of an investment asset. Simple fluctuation in an asset’s price doesn’t trigger capital gains or losses, they simply track your potential value if you were to sell the asset today. So if your stock’s price increases in 2022, you do not owe taxes. However, if you sell that stock and receive the money from that sale in 2022, you will owe taxes in 2022.
What Are Capital Losses
Just as with income, you pay taxes on your capital gains annually. This means that you add up the profits you made from selling investments over the course of the year and pay taxes on it all in one lump sum every April 15. However, taxable capital gains are calculated as your net gains, meaning that you add up your profits over the year and then deduct all of your losses. The result is your net, taxable capital gains for that year.
Capital losses are defined as any sale of an investment asset, such as stocks, in which you lose money. Just like a capital gain, losses have to be realized. This means that you have to actually complete the sale and collect any associated money; mere price fluctuations don’t trigger a loss. You calculate capital losses like you do gains, by the sale price minus the price paid.
So, say you buy 10 shares of stock at $50 per share. You would pay $500 for this stock purchase. Then, say you sell those 10 shares of stock at $40 per share, netting $400. You would lose $100 from this stock sale (the sale price of $400 less the purchase price of $500). This $100 difference is your capital loss.
How to Deduct Capital Losses on Your Taxes
Capital losses, including from the sale of stocks, reduce your taxable capital gains on a dollar-for-dollar basis. If you lose as much as you make in a given year, this can eliminate your taxable capital gains altogether. If you lose more than you make, you can roll a limited amount of capital losses over to your ordinary income as an income tax deduction. Here are the two main ways to deduct capital losses from your taxes.
1. 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).
2. Deduct Excess Losses From Income
Capital losses can apply to ordinary income taxes to a limited extent. If your total capital losses exceed your total capital gains, you carry those losses over as a deduction to your ordinary income. Every year you can claim capital losses up to $3,000 as a deduction on your income taxes (up to $1,500 for married couples filing separately). If your losses exceed $3,000, you can carry those losses forward as tax deductions in future years.
So, for example, say you have a very bad year on 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.
Tax Loss Harvesting
Finally, while a full discussion of this subject is beyond the scope of this article, with careful investing you can conduct what’s known as “tax loss harvesting.” This is the practice of selling assets at a loss in order to maximize the deductions on your taxes.
Usually, the best way to use tax loss harvesting is for timing your sale of already unprofitable assets. If you’re going to lose money on stock anyway, it can be useful to structure the sale around reducing taxable capital gains.
The Bottom Line
Each year, you are taxed on your total capital gains for the year. This means that when you make money selling your stocks you can deduct any money that you lose selling stocks, letting you reduce your total taxable capital gains for the year. This is an important practice to be aware of, especially if you’re not working with a professional so that you can maximize your tax deductions and lower how much you owe.
Tips on Taxes
- It’s always better to avoid potential losses, which is where you may want to consider enlisting help. You can work with a financial advisor who can manage your assets for you or help you create the right asset allocation plan. Finding the right financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three 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.
- Tax loss harvesting may be beyond the scope of this article, but SmartAsset’s Elizabeth Stapleton dives into the subject. If you have to lose money on the stock market, learn how to make it count.
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