A “capital loss” is a term used in investing that describes a capital asset that decreases in value. If you sell a capital asset for less than the price that you paid for it, you will incur a capital loss.
The basic concept of a capital loss is quite simple. A little too simple, right? Well, there’s a bit more to it than that. Incurring a capital loss can affect your taxes in many ways. In fact, many people use capital losses to their advantage. Capital losses can be used as tax deductions, and they can offset the taxes you might have to pay on any capital gains you incur.
There are several layers to capital losses, and there are plenty of ways to use them to your advantage. But there are also limits and regulations that the IRS has put in place that makes figuring out your capital losses and gains a bit more complicated. There are lots of caveats that you must know about before filing your taxes.
Let’s break down the implications and benefits of incurring a capital loss so that you are fully prepared to deal with it when you’re managing your assets.
How a Capital Loss Affects Your Taxes
Incurring a capital loss can affect your taxes. The Internal Revenue Service (IRS) states that if your capital losses exceed your capital gains, you can deduct the excess on your tax return. Those filing their taxes as an individual can claim a net capital loss as a tax deduction against their regular income. This is only allowed for up to $3,000 each tax year, however. If a married individual filing separately incurs a net capital loss, they can claim up to $1,500 of that each year as a tax deduction.
So, once you’ve met the $3,000 or $1,500 limit, what happens to the rest of the net loss? The remaining money can actually be carried over into future years. That means a net loss incurred this year could potentially be applied against capital gains you see in the coming years.
There are exceptions to these tax rules. For example, there are certain types of losses that you cannot carry over to apply against future capital gains. If you sell a personal property like your home and incur a capital loss, you can’t use the excess loss against gains in the future. A capital loss on the sale of a primary residence usually qualifies for tax exemption.
There are also special rules in the cases of wash sales. A wash sale happens when someone sells a security–a stock, option, or bond–at a loss. Then, they buy the same (or almost the same) security right before or after the loss. Losses one incurs after a wash sale are most often not deductible. These rules are also not applicable to a stock that’s sold at a profit.
The point of these wash sale restrictions is to discourage investors that hold unrealized losses from trying to expedite a tax deduction into the current tax year. So, if someone incurs a capital loss and then buys, acquires, or options a similar or identical asset within 30 days before or after the sale, wash sale rules will be applied.
Capital Losses vs. Ordinary Losses
A capital loss is different from an ordinary loss. An ordinary loss can be pretty much anything that is not classified as a capital loss. For example, if you spend $50 to make a painting and then you sell it for $40, you would be left with a $10 ordinary loss.
Ordinary losses also encompass events like casualty, theft, and related-party transactions. A related-party transaction is a deal between two parties who are connected by an already established business partnership or other mutual interest. Related-party transactions are legal, but they can lead to conflicts of interest, so it’s important to be careful. Public companies are required to share any related-party transactions they’ve been involved in with the IRS.
When it comes to taxes, ordinary losses are actually good. For the most part, it’s easier to see tax savings from an ordinary loss than a long-term capital loss. Usually, you can deduct the full cost of an ordinary loss in the year that it happened. However, you can’t do the same with a capital loss. Furthermore, an ordinary loss can be used against both ordinary income and capital gains. Capital losses can only offset capital gains and up to $3,000 of ordinary income, as we mentioned before. The rest of the capital loss must be carried over into future years.
The Different Kinds of Capital Losses
Capital losses can be divided into three separate categories. The first of these is realized losses.
A realized loss is a capital loss that occurs when an asset is sold for a lower price than it was purchased for. A realized loss can be a tax write-off for individuals and businesses.
An unrealized loss is the act of holding an asset that has decreased in price since its purchase, but you aren’t selling it yet. The loss is not “realized” until the asset is sold. Thus, it is only a loss on paper. This unrealized loss could eventually turn into a realized loss. However, if you want to use a loss against capital gains in your taxes, it must be realized.
The third type of capital loss is a recognized loss. A recognized loss happens when an asset or an investment is sold for less than its purchase price. When a person or a business purchases a capital asset, the value of the asset will of course fluctuate. These fluctuations are not considered a profit or a loss until the asset is sold.
Recognized losses are more useful for those who want to plan their taxes strategically. An investor who has capital gains that are going to be taxed this year can plan to recognize a loss on another asset. The planned, recognized loss can help offset the capital gains that they will be taxed on.
Another important thing to note about recognized losses is that they can be applied to future tax years. If someone has no taxable income in a given year, they can use their recognized losses to offset gains in a future year instead.
Filing Capital Losses
When tax season rolls around, you want to be prepared to disclose any capital losses. If you have capital losses to report, you will use IRS Form 8949 in order to report them.
If you owned the investment that produced the capital loss for less than a year, you will report a short-term capital loss. If you owned that investment for more than a year, it’s a long-term capital loss.
Remember that $3,000 limit we talked about for individuals? This is where it comes into play. In the case that your capital losses for the year are greater than your capital gains, you can use up to $3,000 of the capital losses to reduce your net taxable income. Any remaining capital loss past that $3,000 can be applied to future tax years. Again, folks who choose the filing status “married filing separate” can only use up to $1,500.
It’s also important to remember that your investment does not become a capital loss until you sell it. An investment or asset that has decreased in value is not a loss.
Although the word “loss” indicates a deficit, remember that folks can use losses strategically in order to get tax deductions. Incurring a capital loss can therefore be a good thing.
Short-term capital losses are regularly used to deduct against short-term capital gains. Long-term capital losses are deducted against long-term capital gains.
TurboTax offers a very simple example of how these deductions work, which should help to clarify that $3,000 limit. If you find your brain overwhelmed by all the fine print, just hearken back to this breakdown:
- If you have $2,000 of short-term loss and only $1,000 of short-term gain, the net $1,000 short-term loss can be deducted against your net long-term gain (assuming you have one).
- If you have an overall net capital loss for the year, you can deduct up to $3,000 of that loss against other kinds of income, including your salary and interest income.
- Any excess net capital loss can be carried over to subsequent years to be deducted against capital gains and against up to $3,000 of other kinds of income.
- If you use married filing separate filing status, however, the annual net capital loss deduction limit is only $1,500.
Now that you know the difference between ordinary losses and capital losses, the different types of capital losses, and how to report such losses in your taxes, you are set to make strategic investment moves that will help your portfolio grow. As long as you pay close attention to the various rules and caveats that are applied to these types of market transactions, you shouldn’t have a problem. It’s the little details that can get people in trouble. Armed with knowledge, you can make wise investments that will put you in a great position come tax season.