A realized loss during a year can mean a lower tax bill. This loss is generally offset against other gains or income. Some people refer to this as shielding taxable income. However, there are rules on how losses are applied against income. What about losses from previous years? Do the same rules apply? Let’s find out.
Capital losses are losses from capital assets, which include stocks, bonds, primary residence, collectibles, and more. Capital losses are also matched against capital gains. If the capital losses exceed capital gains, up to $3,000 of the loss can be applied to ordinary income.
As an example, an individual incurs a $20,000 capital loss. They have $10,000 in capital gains and an income of $70,000.
Capital gains: $10,000
[less] Capital loss: $17,000
= Capital loss: $7,000
Ordinary income: $70,000
[less] Excess capital loss: $3,000
= Net income: $67,000
Total loss applied: $7,000 + $3,000 = $10,000
Remaining capital loss: $7,000
The remaining capital loss is called a carryover loss. This loss can be applied to income in future years.
Up to $3,000 in carryover losses can be applied to yearly income. From the above examples, $3,000 of the $7,000 capital loss can be applied to the next year, leaving a $4,000 loss to be applied in future years.
Let’s say it is year 2, and we have a $7,000 carryover loss. Capital gains during this year are $2,000, and capital losses are $10,000. The total capital loss for the current year is $8,000 as gains offset losses. $3,000 of the remaining $8,000 loss can be deducted from ordinary income.
The remaining $5,000 capital loss is added to the existing carryover loss for a total of $9,000 in carryover loss. This $9,000 carryover loss can be used to offset income in future years.
A large carryover loss can go on for years. For example, a $90,000 loss can carry on for 30 years. For someone who is 60 years old, there is a chance they may not outlast the carryover period. A carryover loss does not survive the investor when she passes away. Instead, the remaining loss is permanently forfeited.
However, if the loss is part of a joint account (i.e., married couple), it applies to both lives. So if the husband has a big loss and the wife is much younger, the wife can continue using the husband’s loss after he passes.
Investors can’t pick and choose which years they want to apply a carryover loss. A year in which there is no capital gain doesn’t mean the investor can save their annual $3,000 carryover loss for the next year. If there are no gains to offset a carryover loss for that year, the loss is gone forever.
Tax calculations are complex and unique to each individual. This is why it is best to work with a tax specialist on any tax issues.