Capital Losses: They're Just as Ugly as They Sound
Jan 04 '02 (Updated Apr 12 '09)
The Bottom Line Capital losses can be used to reduce taxable income, up to a federally- defined limit, beyond which they can be carried forward to reduce future taxable income.
Making money from the sale of stock, bonds, property, etc., is always a welcome event, even when it represents only a small amount of cash. With each investment that we make as individuals, we cross our fingers hoping that the asset will increase in value.
Capital gains incur additional taxes, since they represent a source of income. But if an asset is sold for less than the price paid, we experience a Capital Loss and we can write the loss off of our taxable income, thereby reducing our taxes. Let's take a closer look at capital losses:
What is a Capital Loss?:
A capital loss is defined as decrease in value that occurs when a capital asset is sold for less than its original purchase price. Capital assets come in many forms, the most popular being stock, bonds, property, and mutual funds. Comparing the original price paid (less commissions) to the sale price (plus any commissions) will determine whether or not you have incurred a loss on the sale.
If you experience a loss, and the loss results from the sale of a capital asset that was held for less than one year, then the loss is referred to as a short- term capital loss. If the asset was held for more than one year, then the loss is referred to as a long- term capital loss.
Tax Implications:
Capital losses are handled in a similar way to capital gains, with a few notable exceptions. The most glaring difference is the fact that capital gains have no limit. No matter how much you gain in a year, it must all be reported for the year it was received. That could very well result in a huge tax burden if the capital gains were substantial.
But with capital losses, the I.R.S. has limits on how much you can write off. You are restricted to a maximum write- off amount of $3,000, or $1,500 (the net total of gains and losses for the year) if you are married and file separately.
What if My Loss is Greater than the Federal Limit?:
If your investments have performed poorly and your loss exceeds the limit, you can still take advantage of the write- off feature of capital losses by the use of capital loss carryover. If your loss is greater than $3,000 (or $1,500), you can carry the excess losses over to future years. There is no limit to the number of years that you can carry losses forward. You can continue to carry forward until the losses are completely exhausted.
Losses that are carried forward retain their original short term or long term status. Therefore, if your original loss is long term, the amount carried forward must be used to reduce the future years' long term capital gains (if any exist), before they can be used to reduce short term capital gains.
Depending on your tax bracket, the carry- forward feature can be beneficial, or detrimental. If your tax bracket increases in the future, then the carry- over feature will save you more tax than you would have saved if the entire loss could be written off in the current year. If your tax bracket declines in the future, then you will save less tax.
For example, let's say that you sell some stock at a total loss of $9,000, in 2001. Your current tax bracket is 15 percent. Your bracket remains at 15 percent in 2002, but then a large pay increase moves you into the 28 percent bracket in 2003. Using these examples, you would be able to write off $3,000 each year for the three years. In the first year, your write- off would reduce your tax burden by $450. In the second year, your tax would be reduced by another $450. But in the third year, your tax would be reduced by $840, because of your increased tax bracket.
Final Thoughts:
Capital losses have an ugly sound to them, but the I.R.S. does help to minimize their impact with the tax write- off provision. It would be better, in most instances, if taxpayers could write- off the entire loss for the year in which it was incurred (unless your tax bracket increases substantially). The I.R.S isn't quite that generous though. They allow the total loss to be written off, but the losses must be carried forward, if they exceed the Federal one- year limit.
It's important to remember that your losses and gains must be combined together, to determine whether or not you will have a net loss for the year. So, if you have a capital loss of $9,000, and a capital gain of $10,000, then your net gain for the present tax year would be $1,000. You can ignore the $3,000 limit on losses per year, because you have an overall net gain of $1,000, in this example. In other words, the $3,000 limit only applies if your total net loss for the year is over $3,000, after any capital gains have been added. If the net sum of gains and losses is no worse than -3,000, then you can claim all the losses in the current year.
With the sluggish performance of the stock market in the past year, many individuals have been forced to sell securities at a loss. If you're one of those unlucky taxpayers who has experienced a capital loss, you can take comfort in knowing that you will save a little in taxes for the current year, and possibly in future years, too.
If losses have you feeling blue, cheer up! The stock market should return to normal again and your losses will turn to gains before you know it. There have been many other bad years for the stock market, and things will change in due time. Until then, write- off what losses you can to reduce the impact of your bad- performing investments.
For more information on federal income taxes, be sure to read the following essays:
Federal Tax Withholding
Federal Exemptions
Short Term Capital Gains and Losses
Long Term Capital Gains and Losses
Standard Deduction
Charitable Contributions
Interest Income
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