Usually, we expect an investment portfolio to increase in value over time. However, an unforeseen market crisis can occasionally lead to a reduction in the value of your investments. When this occurs, the amount that the investment has decreased in value is referred to as a capital loss. Learn more about capital loss deductions and how to use these deductions for a healthier tax return.
The Different Kinds of Capital Losses
Let’s say that Jim invested $50,000 in mutual funds in 2013 and the market downturn in 2020 reduced the total value of his starting investment to $45,000. Jim has two options — he can either hold on to his share in the mutual fund and hope for a subsequent upward trend or sell his share in the mutual fund and “cut his losses,” so to speak.
In the first case, Jim has made an unrealized loss on his investment that cannot be claimed as a capital loss deduction. In the second case, Jim has made a realized loss on his investment because he sold his share. He can now claim the $5,000 loss as a tax deduction for capital loss at the end of the tax year.
Why The Distinction Between Realized and Unrealized Losses is Important
Let’s now consider a third scenario. After the $5,000 loss in value, Jim decides to ride out the dip, and his share in the mutual fund increases to $48,000. At this point, Jim sells his share at its market price for a capital loss of $2,000. As he didn’t sell at $45,000, he can’t claim the $5,000 as a capital loss deduction.
How Tax Deductions for Capital Loss Work
Just as you can claim work-related expenses against your taxable income, you can claim a capital loss against capital gain you made during that same tax year. Let’s say that in 2020, Jim decided to sell his mutual fund investment at $45,000 for a long-term $5,000 capital loss. In that same year, he also made a long-term capital gain of $20,000 on an investment property that he sold. At the end of the tax year, Jim can net the two values, reducing the taxable portion of his long-term capital gain to $15,000.
We’ve considered the case of a capital loss deduction when the amount lost was less than the amount gained, but what happens when the amount lost exceeds the amount gained? Imagine in this case an investor named Martha bought a $1,000,000 property in 2005 and sold it during the Great Recession of 2008 for $900,000. That would be a $100,000 capital loss. In that same year, Martha sold her stock options in the healthcare sector for a capital gain of $10,000.
Martha has to declare the loss in the same year that it’s made. However, she can’t claim a deduction that is greater than the amount of capital gain made during the same year. In this case, Martha can claim $10,000 as a capital loss deduction, and then claim a further $3,000 against her regular income. In the years that follow, she can continue to claim $3,000 against her other types of income during each tax year or use the remaining amount of capital loss to offset future capital gains.
Long-Term vs Short-Term Capital Loss Deductions
Capital gains are taxed at different rates depending on how long you hold on to the investment. This is one way that the IRS rewards investors for holding their investments for a longer period of time. Just like capital gains, capital losses are considered “short term” when the investment was held for one calendar year or less, and “long term” when the investment was held for longer than one calendar year.
Calculating Your Net Capital Loss or Gain
When calculating your tax deduction for capital loss in a given year, use the following formula to net your short-term and long-term gains and losses:
- Step 1: Net Your Long-Term Gains and Losses
- Step 2: Net Your Short-Term Gains and Losses
- Step 3: Net the Two Results for the Final Figure
If we take Martha as an example again, the net capital loss deduction would look like this:
- Long-term gains: $10,000
- Long-term losses: $100,000
- Short-term gains: $5,000
- Short-term losses: $2,000
- Net long-term gain/loss: $90,000 loss ($10,000 LT gain – $100,000 LT loss)
- Net short-term gain/loss: $3,000 gain ($5,000 ST gain – $2,000 ST loss)
- Final net gain/loss: $87,000 loss ($3,000 ST gain – $90,000 LT loss)
From this final amount, Martha can deduct $3,000 against her other types of income and the $84,000 remaining balance will be carried over as a capital loss deduction that she can use in subsequent years.
A Workaround for Maximizing Your Capital Loss deductions
Earlier in this article, we explained that you can only get a tax deduction for capital loss on investments that you actually sell. Often, investors prefer to hold on to their investments in the hope of an upcoming market recovery. There is a way to generate a capital loss while still riding out the change in the market.
To create a capital loss deduction, some investors choose to liquidate their low-performing investments and purchase very similar investments with a different ticker symbol. This means that they can claim the loss against their recognizable gains for the year while making further gains that they can realize in the future.
The reason for purchasing different investments rather than immediately repurchasing the losing shares is that the IRS wash sale rule disallows making a capital loss deduction if you repurchase the investment within 31 days.
Consult a Research-Based Wealth Management Advisor
For investors with a large portfolio, navigating capital loss deductions can become quite complex when there are multiple gains or losses to consider. An advisor from ML&R Wealth Management can help clear up any confusion. Contact our team to schedule your free initial consultation and improve the health of your investment portfolio with our research-based wealth management strategies.