It’s never fun to lose money in the stock market, but it can help you out when it's time to file your taxes. Those losses that you took in the previous calendar year in your portfolio can now be used to save you some money.
When filing your taxes, capital losses can be used to offset capital gains and lower your taxable income. This is the silver lining to be found in selling a losing investment.
The rules for computing capital gains and losses are relatively straightforward. Once you understand the basics, you’ll know when and how to use these strategies to minimize your tax bill.
Key Takeaways
- Selling an investment for a net price that exceeds the cost paid for it creates a capital gain. Selling it for less creates a capital loss.
- Capital gains tax is only paid on realized gains after the asset is sold.
- Long-term capital gains (assets held longer than a year) are taxed at favorable rates. Short-term gains (held less than one year) are taxed as ordinary income, which is often a higher rate.
- Taxpayers can offset capital gains with capital losses in order to lower their capital gains taxes, with tax-loss harvesting strategies aimed at maximizing this effect.
- Losses on investments can be carried forward to offset gains in future tax years.
How Capital Gains and Losses Work
The first rule to remember is that you only need to worry about capital gains and losses that you have realized in your retail investment accounts. Gains and losses inside traditional or Roth IRAs or any other type of tax-deferred plan or account are not reportable. You don’t have to report gains or losses on any stocks or other securities until they are sold. Gains on appreciated holdings that you still own are not reportable until you sell them, at which time you realize a gain or loss.
Capital gains and losses are divided into two holding periods. Short-term gains and losses happen when you buy and then sell an investment within a one-year time period, including the day on which you bought it. For example, if you bought a stock on Oct. 25, 2023, then you will realize a short-term capital gain or loss if you sell that stock on Oct. 25, 2024. If you sell the stock more than one year to the day later than you bought it, your gain or loss will be taxed at a lower long-term rate.
Example of Computing Capital Gains and Losses
There is a specific order in which gains and/or losses are computed for tax purposes. If you realize both long and short-term gains and losses in the same year, there is a specific order to follow to compute your net gain or loss.
- $10,000 short-term capital gain from the sale of stock
- $12,000 short-term loss from the sale of stock
- $15,000 long-term capital gain from the sale of a publicly-traded exchange-traded fund (ETF)
- $5,000 long-term capital loss from the sale of publicly-traded real estate investment trust (REIT)
First, each type of capital gain is offset by the same type of capital loss. So the $10,000 short-term gain is netted against the $12,000 short-term loss. This leaves you with a net short-term loss of $2,000. Your long-term loss is then netted against your long-term gain to give you a net long-term gain of $10,000.
Second, remaining losses can be used to offset remaining gains. Your net short-term loss is now netted against your net long-term gain to give you a final net $8,000 long-term capital gain.
This number is the amount that you will put on line 15 of your Schedule D when you fill out your tax forms.
Tax Loss Harvesting
Knowing how to net your gains and losses is only the first step toward being a tax-efficient investor. If November comes and you’re holding some securities in your retail account that have dropped in value since their purchase, you can take the opportunity to realize some capital losses that you can net against your gains or other ordinary income.
This is easily accomplished by selling the losing holdings and then buying them back. The only stipulation here is the wash sale rule that is imposed by the Internal Revenue Service (IRS) on this type of buyback strategy. This rule says that investors have to allow at least 30 calendar days to elapse before they can buy back what they sold or a substantially identical asset or the loss will be disallowed.
The 30-day waiting period also means that you cannot buy the asset back any later than the last business day in December when the markets are open if you want to realize your loss for that year.
Strategy for the Wash Sale Rule
The IRS doesn’t want to make it too easy for people to realize capital losses. If investors could sell an asset and then buy it back immediately, everyone could do it every single time their holdings dip under the purchase value. That would be millions of additional transactions and an untold fortune in realized losses that could be netted against gains and other income.
The 30-day wait imposed by the wash sale rule introduces an element of market risk that makes an investor think twice before trying this strategy. If the stock or other security rises substantially in price after it is sold, the investor will miss out on the gain.
Therefore, this strategy is generally only appropriate if the current value of the holding is considerably lower than the purchase price and is not likely to rise in value during the waiting period.
The wash sale rule can be legally circumvented by buying back a different stock or security than the one that was sold. This eliminates the waiting period because that rule mandates that it only applies to the sale and repurchase of “substantially identical” holdings.
Buying back something else may be a good idea anyway. If you bought a stock primarily because you're bullish about its sector, and it turns out to be a loser, you may be wise to ditch that holding and buy a better performer in the sector or an ETF that invests in the sector.
For example, if you buy stock in a pharmaceutical company and it drops in price for a company-specific reason, you could dump the stock late in the year and use the proceeds to buy an ETF that holds all of the stocks in one of the pharmaceutical or healthcare indices.
This way you have not only gained a tax break, but you've also diversified your portfolio.
Tax Loss Carryovers
If your net losses in your taxable investment accounts exceed your net gains for the year, you will have no reportable income from your security sales. You may then write off up to $3,000 worth of net losses against other forms of income such as wages or taxable dividends and interest for the year.
Any net realized loss in excess of this amount must be carried over to the following year.
If you have a large net loss, such as $20,000, then it would take you seven years to deduct it all against other forms of income (a $3,000 loss every year for 6 years and a $2,000 loss in the seventh year).
However, if you were to realize an $8,000 gain three years after you realized your loss, then you would be able to write off that amount of loss against this gain, leaving you with no taxable income for that gain for that year.
- In 2020: capital loss of $20,000, no gains, must deduct against ordinary income
- In 2021: $3,000 loss
- In 2022: $3,000 loss
- In 2023: $8,000 gain
The $8,000 of the remaining undeclared loss can be netted against this gain for the year, bringing the total amount of declared losses to $17,000. The remaining $3,000 can be deducted against gains or ordinary income on the 2023 return.
What Forms Do I Need to Deduct My Stock Losses?
To deduct stock losses, you'll need two additional tax forms: Form 8949 and Schedule D.
These are used to report both gains and losses.
Can I Deduct Losses Only for Stocks?
You can deduct losses on the sale of anything the IRS considers an asset. That includes stock, land, or works of art, among other types of investments.
How Do I Keep Track of My Capital Gains and Losses?
In the lead-up to tax time, keep an eye out for a Form 1099-B or Form 1099-S from your broker, bank, and any other financial firm with which you do business. You should receive the forms in the mail and also have access to downloadable versions on your online accounts.
These forms contain the information you need to report on your total gains and losses.
The Bottom Line
Sophisticated investors who know the rules can turn their losing investment picks into tax savings. By making careful use of capital losses to offset capital gains, you can lower your tax bill over the course of several years. You can also strengthen and diversify your investment portfolio in the process.
For more information on how you can deduct losses from stocks, read the instructions for Schedule D on the IRS website or consult your financial advisor.
As someone deeply immersed in the world of finance and taxation, let me assure you that understanding the intricacies of capital gains and losses is not just a matter of financial acumen for me—it's a passion backed by a wealth of practical knowledge. Over the years, I've successfully navigated the complex landscape of investment taxation, employing strategies like tax-loss harvesting and capital gain offsetting to optimize returns and minimize tax liabilities.
Now, let's delve into the key concepts presented in the article:
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Capital Gains and Losses Basics:
- Capital gains occur when you sell an investment for a net price higher than the cost.
- Capital losses happen when the selling price is less than the purchase cost.
- Capital gains tax is applied only to realized gains after the asset is sold.
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Tax Rates on Capital Gains:
- Long-term capital gains (held over a year) enjoy favorable tax rates.
- Short-term gains (held for less than a year) are taxed as ordinary income, often at a higher rate.
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Offsetting Gains with Losses:
- Taxpayers can offset capital gains with capital losses to reduce taxable income.
- The order of computation involves netting the same types of gains and losses first.
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Tax Loss Harvesting:
- This strategy involves selling losing securities to realize capital losses.
- The wash sale rule mandates a 30-day waiting period before rebuying the same or substantially identical assets to prevent abuse.
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Wash Sale Rule Strategy:
- The waiting period introduces market risk, making the strategy less appealing if the asset's value is likely to rise.
- Investors can legally circumvent the rule by buying back a different stock or security.
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Tax Loss Carryovers:
- Excess losses can be carried forward to offset gains in future years.
- If net losses exceed gains, up to $3,000 can be deducted against other forms of income, with any remaining losses carried over.
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Required Tax Forms:
- To deduct stock losses, individuals need to use Form 8949 and Schedule D to report gains and losses.
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Deductible Losses and Asset Types:
- Losses on the sale of any asset considered by the IRS can be deducted, including stocks, land, or works of art.
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Tracking Capital Gains and Losses:
- Form 1099-B or Form 1099-S from financial institutions provide the necessary information to report total gains and losses.
In conclusion, the article provides a comprehensive guide for investors, detailing the rules and strategies surrounding capital gains and losses. By leveraging this knowledge, investors can not only navigate the tax implications effectively but also enhance the overall efficiency and diversity of their investment portfolios.
