When you sell certain assets or investments that have appreciated in value, you may owe taxes on the increased value. The difference between what you paid for the investment and the amount you sold the investment is a capital gain and it is subject to capital gains taxes. However, if you lose money on an investment you can deduct the capital loss.
Capital Loss Deduction
When it comes to taxes, the more tax deductions the better. And, when you lose money on an investment, a tax deduction can take out a little of the sting. However, deducting capital losses can be tricky. Get the rules straight to save on taxes and avoid making mistakes.
Just like with capital gains, there are two kinds of capital losses, short-term capital loss and long-term capital loss. Generally, a long-term capital loss occurs when you have a loss on an investment that you have held for at least one year. Conversely, a short-term capital loss occurs when there is a loss on an investment held for less than a full year.
The tax deduction for capital losses is limited to $3,000 per year against your regular income. That means that you can get a full deduction of up to $3,000 each year, regardless of whether you have any other capital gains. (You can each have up to $1,500 for the year if you are married filing separately.) Capital losses are not a itemized deduction, so they can help even if you are taking the standard deduction.
What if I have capital losses above $3,000?
Offset Capital Gains with Capital Losses
You can offset an unlimited amount of capital gains with corresponding capital losses. For example, if you had an investment that gave you a $10,000 capital gain, and you have another investment that generated a $10,000 capital loss, you can offset the entire $10,000 gain. That means that you do not pay any capital gains taxes on the $10,000. If you had a $13,000 capital loss you could still deduct the entire loss, $10,000 loss against the $10,000 capital gain, and then an additional $3,000 deduction against your regular, non-investment income.
There is a catch, however.
In order to offset gains with losses, the type of loss must match the type of gain. In other words, in order to offset long-term capital gains, you must have long-term capital losses. You cannot use a short-term capital loss to offset a long-term capital gain, or vice versa.
It does not matter if your capital loss is short-term or long-term when it comes to deducting the $3,000 against non-investment income above and beyond any investment gains that you have for the year.
Capital Loss Carryover
If you have more losses than gains to be offset, only the first $3,000 of the losses can be deducted from ordinary income. However, the remaining amount is not lost. Rather, losses can be carried forward to be used on future year’s taxes.
Revisiting our example, assume that you have a $10,000 capital gain for the year, but you have $20,000 in capital losses. You can completely offset the $10,000 gain, meaning you owe no capital gains taxes this year. However, you can only deduct $3,000 of the remaining $10,000 of losses against your regular income. That leaves $7,000 of loss that can be carried forward to next year’s taxes.
In the following year, you can use the entire $7,000 to offset any capital gains. If you have no gains, you can still deduct the $3,000 allowance against ordinary income for the year.
So, if the following year after that you have $5,000 in capital gains, you can offset all $5,000 and still use the remaining $2,000 in losses as a deduction against ordinary income.
How To Claim a Capital Loss Tax Deduction
Capital gains and losses are calculated and reported using Schedule D of Form 1040 and entered on Line 7 of Form 1040.
What is most important about capital losses is that you remember to carry them forward. Users of tax software like Turbo Tax or Tax Cut have this data automatically carried forward by the program if you import last year’s tax returns when you start filing your taxes with the software. However, taxpayers who do their taxes by hand or that switch accountants or tax software need to ensure that their previous year losses are carried forward. Large losses can take years to use up if there are no corresponding large gains to use them against.
Many people have big capital losses to use thanks to recent market volatility. Even if you have tens of thousands of dollars of losses or more, be sure to continue to carry the amount forward. Some day, you’ll make money on an investment and those losses will keep you from having to pay taxes on your gains.
Capital losses can be carried forward forever with no limit on how long they may be used.
Be sure to also understand short sales for capital gains.