Investors hope for capital gains, but taking a capital loss isn't necessarily the worst thing that can happen. A capital loss deduction can be used on your tax return to reduce what you owe the IRS, and it can carry forward to the following years if it's not all used up in the current year.
- A capital gain or a capital loss occurs if you sell an asset for more or less than you paid for it (plus allowable costs).
- The IRS allows you to deduct $3,000 from your taxable income if your capital losses exceed your capital gains.
- Capital losses beyond $3,000 can be rolled over to next year to offset capital gains and ordinary income.
- Tax-loss harvesting is when you realize a capital loss on purpose so that you can use it to offset gains and income in the future.
What Is a Capital Loss?
A capital asset is anything you purchase and own for personal or investment purposes. You would have a capital gain or a capital loss if you were to sell that asset for more or less than your basis in it—what you paid for the asset plus certain allowable costs. The difference between what you paid for the asset and the ultimate sales price represents either a capital gain or a capital loss.
You would have a $5,000 capital loss if you purchased an asset for $50,000, invested $10,000 into maintaining it, then sold it for $55,000. If you sold it for $70,000, you would have a $10,000 capital gain.
Offsetting Capital Gains
Suppose that you have a $5,000 capital loss, and you also have a $5,000 capital gain on the sale of another investment. The gain and the loss would offset each other on your return. You would have no tax loss remaining to carry over to the next year in that situation.
You can't choose to pay tax on the gain this year and roll over the loss to the following year; capital losses must first be used to offset any capital gains of the same type in the current tax year before they can be rolled over to the next.
Offsetting Ordinary Income
You can deduct losses of up to $3,000 from your income if your capital losses exceed your capital gains. For example, if you made $50,000, have a $5,000 loss and no gains, you would still only be able to deduct $3,000—bringing your taxable income to $47,000. The remaining $2,000 of your total $5,000 loss can be carried forward to future years.
Each spouse can deduct only $1,500 against ordinary income if they're married and file separate married returns.
An Example of Carrying Over Losses
Suppose the stock market has a bad year. You sell a stock or mutual fund and realize a $20,000 loss with no capital gains that year. First, you'll use $3,000 of the loss to offset your ordinary income. The remaining $17,000 will carry over to the following year.
Next year, if you have $5,000 of capital gains, you can use $5,000 of your remaining $17,000 loss carryover to offset it. You can use another $3,000 to deduct against ordinary income, which would leave you with $9,000.
The remaining $9,000 will then carry forward to the next tax year. Assuming that you had no capital gains in the following three years, you could use up the remaining $9,000 loss, $3,000 at a time, over those three years.
How to Claim a Loss
Capital gains, capital losses, and tax-loss carry-forwards are reported on IRS Form 8949 and Schedule D, When reported correctly, these forms will help you keep track of any capital loss carryover.
Your total net loss appears on line 21 of the 2020 Schedule D and transfers to line 7 of the 2020 Form 1040 that you'll file in 2021. You can carry forward any excess over the $3,000 or $1,500 limits. The IRS offers a Capital Loss Carryover Worksheet in Publication 550 for guidance.
When to Realize a Capital Loss
Sometimes it makes sense to realize a capital loss on purpose so you can use it to offset capital gains and ordinary income in future years. This concept is referred to as "tax-loss harvesting" and is used by savvy investors.
Ordinary income is taxed at a higher rate than long-term capital gains, so realizing a loss and carrying your capital loss forward so $3,000 of it can offset ordinary income each year can mean a lower tax bill for you. Having a less ordinary income can also mean that less of your Social Security benefits are taxable for the year if you're retired.
The effectiveness of tax-loss harvesting is largely debated in academic circles, but most agree that certain people see more benefits from it than others, based on their tax situation.
Additional Rules and Changes
These gain and loss rules apply primarily to publicly traded investments, such as stocks, bonds, mutual funds, and, in some cases, real estate holdings.
There are additional rules that apply when you realize both short- and long-term gains, and to whether deductions can be used to offset state income, how real estate gains are treated when you must recapture depreciation, and how you account for passive losses and gains.
What Is Capital Gains Tax?
Capital gains tax is a tax on profit from an investment. Assets sold after being held for more than one year are subject to long-term capital gains taxes. Assets held for one year or less are considered short-term capital gains and are taxed as ordinary income.
What Is the Capital Gains Tax Rate?
Long-term capital gains are taxed based on the net capital gain, which is the net long-term capital gain for the year reduced by long-term capital losses, including those carried over from previous years. According to the IRS, the tax rate on most net capital gains is no higher than 15% for most people. If your income is less than $80,000, some or all of your net capital gain may be taxed at 0%. In some situations, the long-term capital gains rate may be 20%, 25%, or 28%.