Long-term and short-term capital gains have different tax rates. There are IRS restrictions on how these different gains/losses are matched and offset each other. In this article, we go over the ins and outs of offsetting capital gains and losses.
Short-term capital gains are those held for less than a year. These gains are taxed at the ordinary income tax rate. Long-term capital gains are those held for a year or more and have favorable tax treatment. Tax rates on these gains cap out at 20% for higher-income earners.
Gains are matched with their holding period. If an investor had $20,000 in long-term (LT) gains and $10,000 in LT losses and decides to realize them, the net gain would look like this:
$20,000 - $10,000 = $10,000
The investor will pay LT gains rates on the $10,000 gain.
If the above were flipped so that the investor incurred a loss:
+ $10,000 - $20,000 = -$10,000 LT loss
Only $3,000 of the LT loss can be declared on the investor’s income taxes. The remaining $7,000 loss is carried forward for use in future years.
The same applies to ST gains/losses, except that ST gains will be taxed at your ordinary income tax rate.
Notice that we always match LT gains with LT losses and ST gains with ST losses. These categories do not cross over to offset each other.
Let’s say that instead of a $10,000 LT loss, the investor had a $5,000 LT loss for the year. They also have the following ST gains:
+ $15,000 (ST gain)
- $5,000 (ST loss)
= +$10,000 ST gain
How does the ST gain factor in with the LT loss? Can one offset the other?
The investor’s net gain for the year will be $10,000. We get that figure by:
+ $10,000 ST gains
- $5,000 LT losses
= +$5,000 ST gains
But what rate are these gains taxed at? Well, there were no LT gains for the year. So the above gains aren’t taxed at the LT rate. These gains are all ST gains and taxed at the ST gains rate.
Remember earlier we said that the ST/LT categories do not cross over? You can see in these examples that ST gains/losses offset each other while LT gains/losses did the same. But once we have the net in each category, we can add them. Only in this case do ST and LT gains/losses offset each other.
Let’s say the investor instead had a net ST loss of $5,000 and a net LT gain of $10,000. They would have been taxed on $5,000 at the LT gains rate.
To summarize, once LT gains/losses are matched, and ST gains/losses are matched, we can net out these two gains/losses to determine which tax rate applies.
The strategic investor might try to ensure that if they have a net gain for the year, it is an LT gain rather than an ST gain. This strategy falls into the category of tax loss harvesting. Working with a financial advisor is best when matching ST and LT capital gains or trying to accomplish tax loss harvesting.