It’s no fun losing money in the stock market. But it does come with a silver lining: You get to deduct your losses. Don’t get too excited, though, because this deduction is strictly limited.
The first thing to know: When do you suffer a loss?
You only suffer a loss or realize a gain for tax purposes when you sell stock or other investment assets. No matter how much your stocks decline, you have no damage to your taxes until you sell them for a loss.
Likewise, no matter how much your stocks go up in value, you have no taxable gain until you sell them.
In short, paper gains are not taxable, and paper losses are not deductible.
Also, don’t worry about gains or losses on stock and other investments you hold in retirement accounts, such as your IRA or 401(k). You need not report on your tax return gains or losses on stock and other investments inside these accounts.
Stocks are capital assets
Stocks fall into a select tax category recognized as “capital assets.” Most of the other investment property you own is also a capital asset. This category includes your mutual funds, bonds, land held for investment, and collectibles like art, and stamps and coins.
Special capital gains tax rates apply to profits you make when you sell long-term capital assets for a profit. These are lower than the tax rates on ordinary income, like salary income you earn from your job.
Special tax rules also apply when you sell stock or another capital asset for a loss. These rules limit how much you can deduct your capital loss from other ordinary income.
How much is your loss?
Understandably, you calculate your loss when you sell stock by subtracting what you paid for it from what you sold it for.
In tax parlance, you subtract the share’s “adjusted basis” from the sales price. The adjusted basis is the amount you paid for the stock plus brokerage fees and any other fees.
For example, if you purchased 100 shares of stock for $1,000 plus $50 commission, your adjusted basis if $1,050. If you sell the stock for $950, you have a $100 loss.
Sometimes, publicly held corporations increase the number of their outstanding shares by doing a stock split. For example, in a 2-for-1 stock split, you get an additional share for each share you own. This change affects the adjusted basis of your stock. In a 2-for-1 split, there will be twice as many shares, so each share’s basis goes down by fifty percent.
Brokers file IRS Form 1099-B, Proceeds from Broker and Barter Exchange Transactions with the IRS each year to report the sales proceeds from stock sales. You also get a copy. The form will show the adjusted basis in your stock as well as its selling price.
Short-term vs. long-term capital losses
The tax treatment of the gain or loss on the sale of stock depends on its holding period.
If you own a stock for more than one year when you sell it, you have a long-term capital gain or loss.
If you own a stock for one year or less when you sell it, you have a short-term capital gain or loss.
You need to keep long-term, and short-term capital gains and losses separate.
Short-term losses and gains: Add up all your short-term gains to get your total short-term gain for the year. Do the same thing with your short-term losses. Then subtract the total loss from the total gain. If the losses exceed the gains, you have a net short-term capital loss.
If the losses are less than the gains, you have a net short-term capital gain. Such an increase gets added to your other income and taxed at the same rate as if it were ordinary income.
Long-term losses and gains: Do the same addition and subtraction for all your long-term capital gains—that is, the stock you owned for more than one year before you sold it. The total is your long-term capital gain or loss.
If you have a long-term capital gain, it gets taxed at the special long-term capital gains tax rate. This rate is 0%, 15% or 20% depending on your taxable income and filing status. It’s usually lower than ordinary income rates.
Figuring capital loss deduction
Both short-term and long-term capital losses are deductible.
You should have two numbers: your net short-term capital gain or loss, and your net long-term capital gain or loss. If you have a net loss in each category, you add them together to determine your total capital loss for the year.
If you have a net loss in one category and a net gain in the other, you subtract the loss from the gain. The resulting number belongs to the category of the larger number. For example, if you have a $10,000 long-term loss and a $5,000 short-gain, you have a $5,000 long-term loss.
$3,000 limit on capital loss deduction
If you have a net capital loss, you can deduct it from other income you earned during the year from other sources. Income from other sources includes salary from a job, interest, or dividends. However, the maximum deduction is no more than $3,000 in capital losses from your ordinary income each year.
What if you lost more than $3,000? You don’t lose your deduction. You carry the unused amount forward to deduct in any number of future years. Each year, you first apply the carried forward losses against capital gains. You then use any remainder (up to $3,000) to reduce your ordinary income.
EXAMPLE: Assume you purchased 1,000 shares of stock nine months ago and sold them for a $10,000 loss. This sale qualifies as a short-term capital loss. This year you also sold stock you purchased ten years ago for a $5,000 profit. This sale garnered a long-term capital gain. You deduct your short-term loss from your long-term gain, leaving a $5,000 net capital loss. You may deduct $3,000 of this loss from your ordinary income for the year. Then, you carry forward the remaining $2,000 loss to deduct in future years.
Claiming your deduction
To deduct losses on stock, bonds, mutual funds and similar investments you must file IRS Form 8949, Sales and Other Dispositions of Capital Assets. You then summaries and report all your capital gains and losses on IRS Schedule D, Capital Gains and Losses.
It’s up to you to decide whether and when to sell a losing stock and deduct the loss. Selling stock to deduct losses is also called tax-loss harvesting. This common tax planning strategy is usually employed at the end of the year. However, you don’t have to wait until the end of the year to sell losing stocks.
Wash sale rule
What’s to stop you from selling losing stocks so you can take a deduction, and then buying them back? The IRS has thought of this strategy. It devised the wash sale rule to combat it.
Because of the wash sale rule, you get no deduction if you sell a stock or other security for a loss and then repurchase it within 30 calendar days. The wash sale rule also applies if you buy stock within 30 days before you sell it.