Topic No. 409 Capital Gains and Losses

Writing off your loss: How it works

The IRS allows you to deduct from your taxable income a capital loss, for example, from a stock or other investment that has lost money. Here are the ground rules:

  • An investment loss has to be realized. In other words, you need to have sold your stock to claim a deduction. You can’t simply write off losses because the stock is worth less than when you bought it.
  • You can deduct your loss against capital gains. Any taxable capital gain – an investment gain – realized in that tax year can be offset with a capital loss. If your losses exceed your gains, you have a net loss.
  • Your net losses offset ordinary income. No capital gains? Your claimed capital losses will come off your taxable income, reducing your tax bill.
  • Your maximum net capital loss in any tax year is $3,000. The IRS limits your net loss to $3,000 (for individuals and married filing jointly) or $1,500 (for married filing separately).
  • Any unused capital losses are rolled over to future years. If you exceed the $3,000 threshold for a given year, don’t worry. You can claim the loss in future years or use it to offset future gains, and the losses do not expire.
  • You can reduce any amount of taxable capital gains as long as you have gross losses to offset them. For example, if you have a $20,000 loss and a $16,000 gain, you can claim the maximum deduction of $3,000 on this year’s taxes, and the remaining $1,000 loss in a future year. Again, for any year the maximum allowed net loss is $3,000.
  • The last day to realize a loss for the current calendar year is the final trading day of the year. That day might be December 31, but it may be earlier, depending on the calendar.

You can enter any stock gains and losses on Schedule D of your annual tax return, and the worksheet will help you figure out your net gain or loss. You may want to consult with a tax professional if your situation is complicated.

It’s also important to know that short-term losses offset short-term gains first, while long-term losses offset long-term gains first. However, once losses in one category exceed the same type, you can then use them to offset gains in the other category. Short-term gains and losses are for assets held less than one year, while long-term gains and losses are for assets held longer than a year.

Because short-term gains and long-term gains may be taxed at different rates, you’ll need to keep your gains and losses straight as you strategically plan your taxes.

In general, long-term capital gains are treated more favorably than short-term gains. So you may consider taking a loss sooner than you might otherwise, in order to minimize your taxes. Or you might try to use low-tax long-term gains to offset more highly taxed short-term gains.

In fact, many investors strategically plan when and how they’re going to realize their losses to ensure they minimize their taxable income each year, typically by realizing investment losses near the end of the tax year. It’s a process called tax-loss harvesting, and it can save you real money. However, tax-loss harvesting is not restricted to year-end, and it can be a useful practice during the year.

Deducting a loss is valuable only in a taxable account, not special tax-advantaged accounts, such as IRAs and 401(k)s, where capital gains aren’t taxed.

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Harvest losses to maximize your tax savings

When looking for tax-loss selling candidates, consider investments that no longer fit your strategy, have poor prospects for future growth, or can be easily replaced by other investments that fill a similar role in your portfolio.

When you’re looking for tax losses, focusing on short-term losses provides the greatest benefit because they are first used to offset short-term gains—and short-term gains are taxed at a higher marginal rate.

According to the tax code, short- and long-term losses must be used first to offset gains of the same type. But if your losses of one type exceed your gains of the same type, then you can apply the excess to the other type. For example, if you were to sell a long-term investment at a $15,000 loss but had only $5,000 in long-term gains for the year, you could apply the remaining $10,000 excess to any short-term gains.

If you have harvested short-term losses but have only unrealized long-term gains, you may want to consider realizing those gains in the future. The least effective use of harvested short-term losses would be to apply them to long-term capital gains. But, depending on the circumstances, that may still be preferable to paying the long-term capital gains tax.

Also, keep in mind that realizing a capital loss can be effective even if you didn’t realize capital gains this year, thanks to the capital loss tax deduction and carryover provisions. The tax code allows joint filers to apply up to $3,000 a year in capital losses to reduce ordinary income, which is taxed at the same rate as short-term capital gains.

If you still have capital losses after applying them first to capital gains and then to ordinary income, you can carry them forward for use in future years.

Where to Report

Report most sales and other capital transactions and calculate capital gain or loss on Form 8949, Sales and Other Dispositions of Capital Assets, then summarize capital gains and deductible capital losses on Schedule D (Form 1040), Capital Gains and Losses.

Capital Gain Tax Rates

The tax rate on most net capital gain is no higher than 15% for most individuals. Some or all net capital gain may be taxed at 0% if your taxable income is less than or equal to $40,400 for single or $80,800 for married filing jointly or qualifying widow(er).

A capital gain rate of 15% applies if your taxable income is more than $40,400 but less than or equal to $445,850 for single; more than $80,800 but less than or equal to $501,600 for married filing jointly or qualifying widow(er); more than $54,100 but less than or equal to $473,750 for head of household or more than $40,400 but less than or equal to $250,800 for married filing separately.

However, a net capital gain tax rate of 20% applies to the extent that your taxable income exceeds the thresholds set for the 15% capital gain rate.

There are a few other exceptions where capital gains may be taxed at rates greater than 20%:

  1. The taxable part of a gain from selling section 1202 qualified small business stock is taxed at a maximum 28% rate.
  2. Net capital gains from selling collectibles (such as coins or art) are taxed at a maximum 28% rate.
  3. The portion of any unrecaptured section 1250 gain from selling section 1250 real property is taxed at a maximum 25% rate.

Note: Net short-term capital gains are subject to taxation as ordinary income at graduated tax rates.

Select the most advantageous cost basis method

Finally, take a look at how the cost basis on your investments is calculated. Cost basis is simply the price you paid for a security, plus any brokerage costs or commissions.

If you have acquired multiple lots of the same security over time, either through new purchases or dividend reinvestments, your cost basis can be calculated either as a per-share average of all the purchases (the average-cost method) or by keeping track of the actual-cost of each lot of shares (the actual cost method).

For tax-loss harvesting, the actual-cost method has the advantage of enabling you to designate specific, higher-cost shares to sell, thus increasing the amount of the realized loss. Learn more about capital gains and cost basis.

Bottom Line

Selling an asset at a loss isn’t the worst thing in the world. In fact, some investors deliberately incur capital losses to lessen their capital gains tax bite. If you’re trying to use a capital loss to offset your gains, just remember to follow the rules so that you can qualify for a tax break.

Classification Between Net Profits and Schedule D Gains (Losses)

Gains and losses are classified as net profits for Pennsylvania if the funds are reinvested in the same line of business within the same entity. Funds are reinvested in the same line of business within the same entity only if the funds are used to acquire like-kind property used in the same business, profession or farm. If the funds are not reinvested then the gains are reported on PA-40 Schedule D. If the gains are reported as ordinary income on federal Form 4797, it is not necessarily reported as net profits for Pennsylvania personal income tax purposes. For purposes of this classification, “Line of business” is defined by the North American Inventory Classification System (NAICS). If the funds are not reinvested in the same line of business, then the gains (losses) are reported on PA-40 Schedule D.

NAICS is a two- through six-digit hierarchical classification system, offering five levels of detail. Each digit in the code is part of a series of progressively narrower categories, and the more digits in the code signify greater classification detail. A complete and valid NAICS code contains six digits that consist of:

  • The first two digits designate the economic sector;
  • The third digit designates the subsector;
  • The fourth digit designates the industry group;
  • The fifth digit designates the NAICS industry; and
  • The sixth digit designates the national industry.

As it relates to classification between net profits and PA-40 Schedule D gains (losses), the first four digits of NAICS are considered as the same line of business. For example, the NAICS code of 336340 would be considered for this purpose as the same line of business as 336312.

Transfers of Property Incident to Divorce

There is no adjustment of the value to the party receiving the property. When the acquiring party disposes of the property, the original cost basis will be used. In addition, the relinquishing party will report no gain or loss on the sale or disposition of the property.

Using Capital Losses to Offset Gains or Income

You can determine how your capital gains or losses will affect your taxes this year and even possibly in upcoming years. Say, for example, you have the following capital gains and losses for 2021:

  • Short-term gain = $0
  • Short-term loss = $20,000
  • Long-term gain = $8,000
  • Long-term loss = $1,500

In this example, you show a short-term loss of $20,000 ($0 – $20,000) and a long-term gain of $6,500 ($8,000 – $1,500). Netted against each other, your gains and losses result in a net loss of $13,500, which eliminates your $6,500 taxable long-term capital gain for 2021.

In this example, you can deduct your net loss of $13,500—but not all at once. The IRS allows you to deduct up to $3,000 in capital losses from your ordinary income each year—or $1,500 if you’re married filing separately. If you claim the $3,000 deduction, you will have $10,500 in excess loss to carry over into the following years.

You can claim up to $3,000 of this money per year against ordinary income until your excess is gone. You can also use this carryover deduction to reduce any capital gains in future years. So, if you realized $10,500 in capital gains in 2022, your excess contributions can reduce your capital gains tax liability to $0.

Losses when disposing of assets to family and others

Your husband, wife or civil partner

You usually do not pay Capital Gains Tax on assets you give or sell to your spouse or civil partner. You cannot claim losses against these assets.

Other family members and ‘connected people’

You cannot deduct a loss from giving, selling or disposing of an asset to a family member unless you’re offsetting a gain from the same person.

This also applies to ‘connected people’ like business partners.

Connected people

HMRC defines connected people as including:

  • your brothers, sisters, parents, grandparents, children and grandchildren, and their husbands, wives or civil partners
  • the brothers, sisters, parents, grandparents, children and grandchildren of your husband, wife or civil partner – and their husbands, wives or civil partners
  • business partners
  • a company you control
  • trustees where you’re the ‘settlor’ (or someone connected to you is)

Bankrupt companies are an exception

If you own a stock where the company has declared bankruptcy and the stock has become worthless, you can generally deduct the full amount of your loss on that stock — up to annual IRS limits with the ability to carry excess losses forward to future years.

The IRS will expect you to have sufficient documentation of your cost basis in the stock to show the amount you lost in this situation. There is no need to actually sell the shares to claim a capital loss.

Short-Term and Long-Term Capital Losses

Capital gains and losses fall into two categories: long-term gains and losses and short-term gains and losses. If you sell an investment you owned for a year or less, it’s considered a short-term gain (or loss). If you sell an asset you’ve held for over a year, it counts as a long-term loss or gain.

These classifications come into play when calculating net capital gain. In order to use your losses to offset your gains, you must first group them together by type. Short-term losses must initially be deducted from short-term gains before you can apply them to long-term gains (and vice versa).

Short-term capital gains are taxed like ordinary income. That means your tax rate might be as high as 37%. And depending on your income, you might also owe a 3.8% Medicare surtax.

Tax rates for long-term capital gains, on the other hand, are generally much lower. If you’re in the 10% or 15% tax bracket, you won’t owe any taxes if you have long-term capital gains. If you’re in a higher tax bracket, you’ll face a 15% or 20% tax rate.

You may want to consider selling your assets at a loss when you have short-term capital gains (or no gains at all). That way, you’ll minimize your tax bite and eliminate low-performing investments at the same time.

Using losses to reduce your gain

When you report a loss, the amount is deducted from the gains you made in the same tax year.

If your total taxable gain is still above the tax-free allowance, you can deduct unused losses from previous tax years. If they reduce your gain to the tax-free allowance, you can carry forward the remaining losses to a future tax year.

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