Can Capital Losses Offset Ordinary Income?

Ordinary income is, quite simply, what you earn from providing products or services to others. The wage or salary your employer pays you falls under the category of ordinary income. Interest income from bonds also falls into this category. If you’re retired and taking withdrawals from your defined contribution plan, that withdrawal is also considered ordinary income.

The challenge of ordinary income is that the more you earn, the higher your tax rate. But there are ways to help reduce the amount of your ordinary income. One such approach is to use any capital losses you generate to help offset your ordinary income. But there are limits to this method.

What is a Capital Loss?

First, let’s define capital loss. When you sell a capital asset (think stocks, bonds, mutual funds, or investment real estate), the process will end in one of two ways. You’ll either generate a profit, or capital gain. Or you’ll generate a capital loss, which is the difference between what you paid for the asset minus the price you sold the asset for.

You’re not taxed on capital losses as you would be on capital gains – there’s nothing to tax if you sold an asset at a loss. But you could deduct that loss against any capital gains earned during the year. A short-term loss (when a capital asset is held for less than a year) is deducted from a short-term gain. A long-term gain (on assets held for one year or longer) is deducted from a long-term gain.

Once those capital losses are deducted from their corresponding capital gains, it’s possible to deduct them against other income. Like ordinary income.

Capital Losses and Ordinary Income

While you can apply a capital loss to offset ordinary income, there’s a limit on how much of that loss you can use. The IRS is pretty specific that the most you can use to offset that income is $3,000 a year (or $1,500 if you’re married and filing separately). If your capital loss exceeds that $3,000 limit, you can carry that loss forward to offset income in later years.

For example, if your capital loss is $5,000 in a given year, and there are no capital gains to offset, you could use $3,000 in that first year as an offset against ordinary income. Then, the following year, you could use the remainder as an offset to ordinary income in that year.

A Tax Strategy?

A capital loss can be part of a deliberate tax strategy known as tax loss harvesting. This happens when you deliberately sell an underperforming asset, take the loss, and then offset it against capital gains, then ordinary income. But this is a tricky strategy, best done with assistance from a qualified tax advisor.

Otherwise, it’s possible to use capital losses to offset ordinary income, as long as any capital gains are offset first, and you keep within the IRS’ mandated limit.