Capital Loss Deduction

 

In life, no one wishes to invest and lose, no matter how little the investment seems to be. The goal of every investor is to make a good return out of investments. However, even the best investors like the likes of Warren Buffet cannot escape capital loss. Capital loss is bound to happen in one way or the other. One comforting note about experiencing a loss in investment is that losses can be used to reduce your overall income tax. To get a good tax benefit, you should understand how to tactically use your loss to earn valuable tax savings from your investment. 

What Capital Loss Can Be Used For

• Capital loss can be used to reduce your tax bills
• It can be used to offset capital gain during a taxable year, thereby giving you the privilege to remove some income from your tax return
• Capital loss can also be used to offset ordinary income of up to $3,000, especially when you don’t have capital gain to offset the capital loss
• If you have a stock that has become invaluable either because the company was liquidated or it went bankrupt, you can take a capital loss on such stock.

What is capital loss?

A capital loss is simply defined as the money difference between an investment original purchase price and the price it is sold for. A capital loss is experienced when an investment is sold at a price lower than the original purchase price. The difference in the dollar between the purchase price and the price it is sold for is calculated as the capital loss. Conversely, capital gain is when an investment is sold for a price higher than the original purchase price. The difference in the purchase price and the price the investment is sold for is referred to as capital gain. Hence capital gain is the opposite of capital loss. 

However, it is important to note that for income tax reduction purposes, capital loss can only be used for an investment that is expected to increase in value. But rather than an increase, what happened was a loss. This implies that there is no tax deduction on personal items like automobiles, though the sales of a car or other personal belongings are still considered taxable. 

Types Of Capital Loss

For tax benefits, there are three types of capital loss, they include:

• Realized losses
• Unrealized losses
• Recognizable losses

Realized losses are losses that occur on the actual sales of an investment or asset. As such, they are reported for tax benefit. Unrealized losses are losses that are not reported while recognizable loss is the stipulated amount of losses that can be declared in a given period of time. For tax benefit, the stipulated amount of tax that can be deducted in a year is up to $3,000. If the capital loss is more than this amount, the remaining can be calculated and deducted in future years. If a capital gain is experienced in subsequent years after a loss, the gain can be used to offset the remaining capital loss rolled over from the previous year.

Among these three types of capital loss, according to the U.S tax law, the only capital loss that can be calculated and deducted is the realizable capital loss. 

To calculate the realized and unrealizable capital loss, take, for instance, an investor invests $50 in stock in January. During the month of May, the price of the stock reduces to $30. The unrealized loss is $20. However, the investor refused to sell the stock at this period and waited for an additional four months. 

Having waited for four months, in September, the price of the stock increased to $45. Although this is still not up to the original purchase price, the investor decides to sell the stock. The realizable loss on stock is therefore $5. In this case, the price that would be reported as a capital loss would not be the unrealized $20 but the realized $5. 

Capital loss on stocks or investments become realizable when it is sold. 

As already explained, there is a limit to the amount of capital loss that can be reported in a year. Although all gains on investment can be reported as recognizable gain, this is not the same with capital loss. In the case of capital loss, the maximum amount of capital loss that can be reported is $3,000.

How To Calculate And Use The Capital Loss On Income Tax

Capital loss is calculated and claimed using section D of your Form 1040 tax return. The amount you will be allowed to deduct will depend on the type of income and investment.  

In filing the capital loss, the total net loss will be filled on line 21 of your 2019 section D, and then transferred to the 2019 Form 1040 that you would fill in 2020. If your loss is more than $3000, you can carry it over to the next year. 

It is important to note that the Forms 1040 for 2018 and 2019 are not the same. The IRS redesigned the form for both years. However, this is only applicable to the forms of both years.

In terms of carrying over any excess more than the $3,000, the IRS offers a Capital Loss Carryover Worksheet in Publication 550 for guidance.

How To Use A Capital Loss To Offset Capital Gains

Assuming the loss you experienced from your stock is $5,000, but in the same year, you experienced a capital gain of equivalent amount. The gain and loss would offset each other on your return. Hence, there won’t be any tax loss for you to carry over till the next year. 

If you experience a loss and gain similar to the above, you can’t choose to pay tax on the gain this year and roll over the remaining loss to the next year. This is because, before rolling over a capital loss, it must first be used to offset any available capital gains. 

How To Use A Capital Loss To Offset Ordinary Income

Assuming you experienced a capital loss of $5,000 and do not have any capital gain to offset with the loss. The next option is to offset your ordinary income. However, the maximum amount of loss that can be deducted from your income is $3,000. 

Assuming you only earn an income of $50,000 and your loss is $5,000. When you deduct $3,000 from your income, you will have an income of $47,000. This implies that the income tax you will be required to pay would only be on the remaining $47,000. For the remaining $2,000, you will have to roll it over to the next year since you have no capital gain to offset it with.

How To Carry Over Loss

Let’s assume the stock market experienced a bad year such that your capital loss is $20,000 with no capital gain. 

The first thing to do is to offset $3,000 of your loss and then carry over the remaining $17,000. 

If in the next year, you have a total capital gain of $5,000. You can offset this with the remaining $17,000 loss that was carried over from the previous year. After this, use another $3,000 to deduct against ordinary income. The total amount of capital loss remaining would be $9,000.

If in the next three years you don’t have any capital gain, you will offset the loss $3000 per year. This will equally take three years to offset.

How Short Term And Long Term Loss Are Calculated

The tax law distinguished between short term and long term loss. Calculating the short and long term loss is very simple. A capital loss that is more than a year is regarded as a long term loss while a capital loss that is less than a year is regarded as a short term loss.

To calculate your capital loss deduction, if your loss is short term, you will first offset the short term loss with the short term capital gain or ordinary income. 

In the same vein, for long term loss, you will first offset the capital loss with a long term capital gain or ordinary income. After this deduction, whatever remains retains its character. For instance, if your short term loss is bigger than the short term gain, the remaining figure will be no longer be a short term loss because it will be rolled over. What you have would be a long term loss. However, if your long term gain is higher than the long term loss, what remains is a long term gain. 

Irrespective of whether it is a short term gain or loss, the most important thing is that you calculate your gain and loss very well so as to benefit from income tax.