Capital Losses and Tax

Mark Cussen, CMFC, has 13+ years of experience as a writer and provides financial education to military service members and the public. Mark is an expert in investing, economics, and market news.

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A capital loss occurs when you sell a capital asset for less than you bought it. It's never fun to lose money on an investment, but declaring a capital loss on your tax return can be an effective consolation prize in many cases.

That's because capital losses can be applied against capital gains or other income to reduce taxable income. Investors who understand the rules of capital losses can often generate useful deductions with a few simple strategies.

Key Takeaways

• A capital loss exists when a security is sold for less than its purchase price.
• A capital loss can be used to reduce the tax burden of future capital gains and other income.
• There are three types of capital losses—realized losses, unrealized losses, and recognized losses.
• Capital losses allow investors to offset capital gains and other forms of income on their tax returns, and thus reduce taxable income.

Capital Loss Basics

Capital losses are, of course, the opposite of capital gains. When a security or investment is sold for less than its original purchase price, then the dollar amount difference is considered a capital loss.

For tax purposes, capital losses are only reported on items that are intended to increase in value. They do not apply to items used for personal use such as automobiles (although the sale of a car at a profit is still considered taxable income).

Tax Rules for Capital Losses

Capital losses can be used as deductions on the investor’s tax return, just as capital gains must be reported as income. Unlike capital gains, capital losses can be divided into three categories:

1. Realized losses occur on the actual sale of the asset or investment.
2. Unrealized losses are not reported.
3. Recognized losses are the amount of a loss that can be declared in a given year.

When Deductions Can Be Taken

Realized Losses

Any amount of capital loss can be netted against any capital gain realized in the same tax year, but only $3,000 of capital loss can be deducted from earned or other types of income in the year. Remaining capital losses can then be deducted in future years up to $3,000 a year. Or a subsequent capital gain can be used to offset the entirety of the remaining carry-forward loss amount.

Unrealized vs. Realized Losses

An investor buys a stock at $50 a share in May. By August, the share price has dropped to $30. The investor has an unrealized loss of $20 per share. They hold the stock until the following year, and the price climbs to $45 per share. The investor sells the stock at that point and realizes a loss of $5 per share. They can only report that loss in the year of sale; they cannot report the unrealized loss from the previous year.

Realized Losses and Recognized Gains

Another category is recognized gains. Although all capital gains realized in a given year must be reported for that year, there are some limits on the amount of capital losses that may be declared in a given year in some cases.

Again, while any loss can ultimately be netted against any capital gain realized in the same tax year, only $3,000 of capital loss can be deducted against earned or other types of income in a given year.

For example, say that Frank realized a capital gain of $10,000. He also realized a capital loss of $30,000. He will be apply $10,000 of his loss against his gain, but can only deduct an additional $3,000 of his loss against his other income for that year.

Then, he can deduct the remaining $17,000 ($20,000 - $3,000) of his capital loss in $3,000 increments from income every year from then on until the entire amount has been deducted.

However, if he realizes another capital gain in a future year before he has exhausted this amount, then he can deduct the total remaining loss against that gain.

So, say he deducts $3,000 of that $17,000 loss in each of the next two years and then realizes a $20,000 capital gain. Frank can then deduct the remaining $11,000 of loss ($17,000 - $6,000) from that capital gain, leaving a taxable gain of only $9,000.

A recognized gain is the portion of a realized gain that is taxable. A capital loss reduces a realized gain to a recognized gain.

How to Calculate a Capital Loss

Capital losses mirror capital gains in their holding periods. An asset or investment that is held for a year or less, and sold at a loss, will generate a short-term capital loss. An asset or investment held for more than a year, and sold at a loss, will generate a long-term loss.

When capital gains and losses are reported on the tax return, the taxpayer must first categorize all gains and losses between long and short term and then aggregate the total amounts for each of the four categories.

Next, the long-term gains and losses are netted against each other, and the same is done for short-term gains and losses. Finally, the net long-term gain or loss is netted against the net short-term gain or loss. This final net number is then reported on Form 1040.

Example

Say that Frank had the following gains and losses from his stock trading for the year:

• Short-term gains: $6,000
• Long-term gains: $4,000
• Short-term losses: $2,000
• Long-term losses: $5,000

He must now net out the short-term gains and losses and the long-term gains and losses:

• Net short-term gain: $4,000 ST gain ($6,000 ST gain - $2,000 ST loss)
• Net long-term loss: $1,000 LT loss ($4,000 LT gain - $5,000 LT loss)

Next, he subtracts his capital loss from his capital gain for a final figure:

• Final net gain/loss: $3,000 short-term gain ($4,000 ST gain - $1,000 LT loss)

Had Frank realized a final capital loss of more than $3,000, he would only be able to deduct $3,000 of it from other types of income for that year. He would have to carry forward any remaining balance.

Tax Reporting

Taxpayers use Form 8949 to record detailed information about capital gains and losses. They then provide this to the Internal Revenue Service (IRS) with their tax return so that the agency can compare the information with that reported by brokerage firms and investment companies.

Taxpayers transpose the final net number from Form 8949 to Schedule D and then to Form 1040.

Capital Loss Strategies

Although novice investors often panic when their holdings decline substantially in value, experienced investors who understand the tax rules are quick to liquidate some of their losers to generate capital losses.

Smart investors also know that capital losses can save them more money in certain situations. That is, capital losses used to offset short-term gains or other ordinary income will save investors more money than when used to offset long-term capital gains.

That's because they're reducing the amount of taxable income subject to ordinary income tax rates, which are higher than capital gains tax rates.

Wash Sale Rules

Investors who liquidate their losing positions must wait at least 31 days after the sale date before buying the same securities back if they want to deduct the loss on their tax returns. If they reinvest before that time, the loss will be disallowed under the IRS wash sale rule.

This rule may make it impractical for holders of volatile securities to attempt this capital loss strategy, because the price of the security may rise again substantially before the waiting period ends.

But there are ways to circumvent the wash sale rule in some cases. Savvy investors will often replace losing securities with either very similar or more promising alternatives that still meet their investment objectives.

For example, an investor who holds a biotech stock that has tanked could liquidate this holding and purchase an ETF that invests in this sector as a replacement. The fund provides diversification in the biotech sector with the same degree of liquidity as the stock.

Furthermore, the investor can purchase the fund immediately, because it is a different security than the stock and has a different ticker symbol. This strategy is thus exempt from the wash sale rule, as it only applies to sales and purchases of identical securities.

How Much Capital Loss Can You Claim?

Per IRS rules, the amount of capital loss you can claim is as follows: "If your capital losses exceed your capital gains, the amount of the excess loss that you can claim to lower your income is the lesser of $3,000 ($1,500 if married filing separately) or your total net loss shown on Schedule D.

Are Capital Losses Tax Deductible?

Yes, capital losses are tax deductible up to a limit. After netting out short- and long-term capital gains and losses for a possible net loss, the loss can offset any income, up to $3,000.

How Do I Claim a Capital Loss on a Tax Return?

To claim capital losses on your tax return, you will need to file all transactions on Schedule D of Form 1040, Capital Gains and Losses. You may also need to file Form 8949, Sales and Other Disposition of Capital Assets.

The Bottom Line

Investors may hate to see investment losses but there's good news. Capital losses can be used to reduce taxable income. For more information on capital losses and including them on your tax return, download the Schedule D instructions from the IRS website or consult your financial advisor.

1. Internal Revenue Service. "Topic No. 409, Capital Gains and Losses."
2. Internal Revenue Service. "Publication 544, Sales and Other Dispositions of Assets."
3. Internal Revenue Service. "Instructions for Form 8949."
4. Internal Revenue Service. "About Schedule D (Form 1040), Capital Gains and Losses."
5. Internal Revenue Service. "Publication 550, Investment Income and Expenses."
6. Internal Revenue Service. "2023 Instructions for Schedule D,"

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