Losing money in the stock market stings, but capital losses don’t have to be all bad news for your finances. A tax rule known as the capital loss carryover offers a major long-term tax break investors can use strategically to reduce what they owe the IRS for years, or even decades, into the future. The capital loss carryover lets filers deduct up to $3,000 in net capital losses from their taxable income each year indefinitely, until their excess capital losses are exhausted. By offsetting capital gains and other income with this deduction, filers can lower their tax bills and hang onto more of their hard-earned money.
Do you have questions about tax planning strategies? Speak with a financial advisor today.
Capital Loss Carryover Concepts
The capital loss carryover rule allows individual investors to use net capital losses from selling securities at a lower price than the original purchase price to reduce their taxable income. This includes losses from selling stocks, bonds, mutual funds, exchange-traded funds (ETFs) and other capital assets.
The IRS allows no more than a maximum $3,000 carryover loss benefit in any given year. For married couples filing separately, this shrinks to $1,500 a year.
So, if your total net loss in a given tax year exceeds $3,000, you can continue claiming the maximum $3,000 deduction from your income that year and every year going forward until you reach the full amount. In turn, there’s no limit to how many years you can keep deducting the unused portion of a loss. That means if you have a sizable loss in one year, you could potentially take the maximum loss every year for quite some time until you’ve exhausted it. Of course, that doesn’t account for if you have any further losses to deduct in upcoming years.
The deductions can be taken against both your ordinary income and capital gains. You report capital losses on both IRS Form 1040 Schedule D and Form 8949.
You also may be able to apply the capital loss carryover strategically as part of an overall tax minimization plan. Some of the moves you might take to do this could include:
- Tax-loss harvesting at year end to offset realized capital gains
- Limit trades to reduce taxable gains and excess losses
- Invest in assets favorable for long-term gains taxed at lower rates
- Use losses judiciously over time as part of retirement income drawdown strategy
Limits of the Capital Loss Carryover Rule
While the capital loss carryover offers a valuable tax break, it comes with limitations and risks. For one, the $3,000 maximum deduction may not be enough to fully offset a large capital gain in a given year. It also can sometimes take many years to use all the losses from a year or years that include more than $3,000 of them. That’s what makes this strategy truly long-term, since you may not be able to take full advantage until years down the road.
However, perhaps the most important thing to remember when using this deduction is to abide by the wash-sale rule. This states that investors cannot realize a capital loss tax benefit by selling an investment at a loss, and then buy back a substantially similar investment within the 30-day window that follows.
Violations of the wash-sale rule can disallow capital losses claimed through tax-loss harvesting. In other words, be cognizant of this rule as you look to take advantage of any losses you might incur while investing.
An Example of a Capital Loss Carryover
A hypothetical example can help illustrate how the capital loss carryover rule works. For instance, let’s say an investor bought $10,000 worth of stock in 2022, then sold the shares in 2023 for $4,000, realizing a $6,000 capital loss. In 2023, this investor also has $3,000 in capital gains from other investments, plus $50,000 in taxable income from their job. Because they gained $3,000 from other investments and lost $6,000 on the stock sale, their net total loss was $3,000.
Using the capital loss carryover rule, they can apply that net capital loss to offset ordinary income, deducting it directly from their $50,000 salary. This brings the taxable portion of their ordinary income down to $47,000 for the year, which should save them a few hundred bucks at tax time.
On the flip side, if their net losses were, say, $6,000, then they could still only claim the $3,000 loss this year, but then next year they’d have another $3,000 they could apply. This is what can make this rule truly a long-term benefit.
Bottom Line
The capital loss carryover offers investors an opportunity to make investing lemons into tax lemonade. While market downturns create losses, this rule lets you deduct those losses over time to reduce your income taxes for years. An investor can use this rule strategically along with sound fundamental investing practices to ease the pain from investment losses and boost long-term, after-tax returns.
Tax Management Tips
- A financial advisor can help you build a tax strategy that accounts for capital gains, income and more. 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.
- Use SmartAsset’s investment return and growth calculator to project the future value of your portfolio. All you need to do is assume an average growth rate, what your initial investment will be, how much you’ll contribute on an ongoing basis and how long you expect the assets to grow for.
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