A capital loss is an economic event that occurs when a capital asset is sold for a price lower than its adjusted basis. Capital assets encompass a broad range of property, including investments like stocks and bonds, real estate, and valuable collectibles. For a business entity, a capital asset is typically defined as property with a useful life exceeding one year that is not held for regular sale in the course of business.
When an investor disposes of an asset and the proceeds are less than the initial investment, a capital loss is realized. This is the direct opposite of a capital gain, which is realized when an asset is sold for a profit. It is critical to understand that a capital loss is only "realized" for tax purposes upon the actual sale or disposition of the asset. A decrease in an asset's market value while it is still held by the investor is considered an "unrealized" or "paper" loss and has no immediate tax consequence.
Not all realized losses on personal property qualify as deductible capital losses. For instance, losses incurred from the sale of a personal residence or automobile are generally not deductible for tax purposes. However, losses from the sale of investment assets, such as stocks, bonds, and mutual funds, can often be used to offset capital gains and, in some cases, ordinary income, thereby reducing an investor's overall tax liability.
Calculating a Capital Loss
To accurately determine the amount of a capital loss, an investor must first establish the asset's adjusted basis. The adjusted basis is the original cost of the asset, including any transactional fees like brokerage commissions, plus the cost of any subsequent capital improvements.
The calculation for a capital loss is as follows:
- Determine the adjusted basis: This is the total cost to acquire the asset.
- Identify the sale price: This is the total amount received from the sale of the asset.
- Subtract the sale price from the adjusted basis: If the result is a positive number, that figure represents the capital loss.
For example, if an investor purchases 100 shares of a stock at $50 per share with a $10 commission, the total basis is $5,010. If those shares are later sold for $4,000, the capital loss is calculated as $5,010 (adjusted basis) - $4,000 (sale price) = $1,010.
It is imperative to remember that a capital loss is only claimable upon the sale of the asset. For equity investments, the cost basis may require adjustment for corporate actions such as stock splits. In a 2-for-1 stock split, for instance, an investor would double the number of shares owned but must halve the cost basis per share.
Taxpayers use Form 8949, "Sales and Other Dispositions of Capital Assets," to report these transactions. Short-term losses, from assets held for one year or less, are reported in Part I. Long-term losses, from assets held for more than one year, are reported in Part II. These totals are then aggregated on Schedule D, "Capital Gains and Losses," to calculate the net capital gain or loss for the tax year.
Tax Implications of Capital Losses
Capital losses serve as a valuable tool for tax management. The primary function of a realized capital loss is to offset capital gains. The tax code specifies an order of operations for this process.
- Short-term capital losses must first be used to offset short-term capital gains.
- Long-term capital losses must first be used to offset long-term capital gains.
If excess losses remain in one category, they can then be used to offset gains in the other. For example, if an investor has $10,000 in long-term losses and only $4,000 in long-term gains, the remaining $6,000 in long-term losses can be used to offset any short-term gains.
Should an investor's total capital losses exceed their total capital gains, they can deduct up to $3,000 of the excess loss against their ordinary income for the year. This limit is $1,500 for those who are married and filing separately. Any capital loss amount that remains after offsetting gains and the allowable ordinary income deduction can be carried forward to subsequent tax years indefinitely. This capital loss carryover retains its character as either short-term or long-term.
Reporting Capital Losses on Tax Returns
Properly reporting capital losses is essential to realizing their tax benefits. The process involves meticulous record-keeping and accurate completion of specific tax forms.
The primary forms for reporting are Form 8949 and Schedule D, which are filed with an individual's Form 1040 tax return.
The process is as follows:
- List all transactions on Form 8949: Each sale or disposition is detailed, with short-term transactions in Part I and long-term transactions in Part II.
- Calculate net short-term and long-term figures: The totals from Form 8949 are transferred to Schedule D to calculate the net short-term and net long-term capital gain or loss.
- Determine the total net capital loss: These two figures are combined on Schedule D to arrive at the total net capital gain or loss for the year.
- Apply the deduction limit: The lesser of the total net loss or $3,000 ($1,500 if married filing separately) is entered as a deductible loss on Form 1040, line 7.
Investors must be aware of certain rules that can disallow a loss. Losses on sales between related parties, such as family members, are generally not deductible. Additionally, the "wash sale" rule prevents an investor from claiming a loss on a security if they purchase a "substantially identical" security within 30 days before or after the sale.
Frequently Asked Questions (FAQs)
1. How do you calculate capital losses for tax purposes?
Capital losses are calculated by first netting short-term gains against short-term losses and long-term gains against long-term losses, as reported on Form 8949 and summarized on Schedule D. The resulting net short-term and long-term figures are then combined to determine the overall net capital gain or loss for the year.
2. Can a $3,000 capital loss be deducted from your taxes?
Yes. If your total capital losses exceed your total capital gains, you can deduct up to $3,000 of the excess loss against your ordinary income. This limit is set by IRC Section 1211(b). Any loss amount exceeding this $3,000 limit can be carried forward to future tax years.
3. Is it possible for capital losses to reduce ordinary income?
Yes. After offsetting all capital gains, up to $3,000 of net capital losses can be used to reduce an individual's ordinary income (such as wages) each year. This makes capital loss harvesting a strategic tool for lowering overall tax liability.
4. What are some examples of capital losses?
A capital loss occurs when a capital asset's sale price is lower than its purchase price or adjusted basis. For instance, if an investor buys shares in a company for $10,000 and later sells them for $7,000, they incur a capital loss of $3,000. This loss can then be used to offset capital gains for tax purposes.
