Do Capital Losses Reduce Taxable Income?

Posted Feb 8, 2023


If you take a loss on a stock, can that loss be used to reduce your taxable income? Reducing taxable income results in a lower tax bill, something most any investor would be interested in. However, there are certain rules around capital losses, and the income from those losses can be applied to. This article will dig into the gritty details of using capital losses to reduce taxable income.

Understanding Capital Gains And Loss

Capital gains come from the sale of capital assets. These include stocks, bonds, and your primary residence, among other assets. As you probably guessed, a capital loss is a loss taken on a capital asset.

The net of these gains and losses during a year creates an asset's capital gain or loss. For example, an investor who sold StockA for a gain of $4,000 and also sold StockB for a loss of $5,000 has a capital loss of $1,000.

In the above case, the investor used a capital loss to reduce taxable income. The loss completely wiped out the $4,000 gain. Otherwise, the investor would have had to pay taxes on the $4,000 gain.

Note that stock investors can get caught in a wash sale. Selling a stock at a loss and buying it back within the wash sale time frame disallows the loss, and the investor has generated a wash sale rather than a capital loss.

Capital Losses Applied To Other Taxable Income

In an ideal world, you could sell capital assets at a loss and use that loss to offset ordinary income. But in an ideal world, there isn't an IRS. And the IRS says if you have earned income, you need to pay taxes on it. Since capital losses are not earned income, they can't be applied to ordinary income, at least to a limit.

Capital losses can be used to offset ordinary income if the loss is $3,000 or less. What does this mean if you have a $10,000 capital loss? It means that $3,000 of the loss can offset ordinary income. The remaining $7,000 carries into the next year, where $3,000 can be used to offset income in the following year. In the year after, another $3,000 can be used. And on it goes until all the carryover has been used.

As an example, an investor incurs a $1500 capital loss. The investor earns $100,000 per year. The loss can be applied to the investor’s earned income, reducing it to $98,500.

Another investor earns the same amount of income but has a $5000 capital loss. $3,000 can be applied to ordinary income, reducing it to $97,000. The remaining $2,000 is a carryover loss that can be applied to income in the following year.

Retirement accounts cannot claim capital losses since they already receive favorable tax treatment. However, an investor may be able to use a loss on distributions. It's best to work with an accountant in this situation.

Tax Forms

Form 8949 (Sales and Other Dispositions) is used to report each (capital) sale transaction. The totals from Form 8949 go onto Schedule D. Schedule D also includes any capital loss carryover amounts. Schedule D totals, then flow to your Form 1040.

Investors may find that they have many capital sales transactions, resulting in a mixture of short and long-term capital gains and losses. Netting all of these transactions out can be a complicated and tedious process. That’s why it's generally best to work with a tax specialist, who can help ensure you're getting the most out of your capital gains/losses tax treatment.

This material is for general information and educational purposes only. Information is based on data gathered from what we believe are reliable sources. It is not guaranteed as to accuracy, does not purport to be complete and is not intended to be used as a primary basis for investment decisions. It should also not be construed as advice meeting the particular investment needs of any investor.

Realized does not provide tax or legal advice. This material is not a substitute for seeking the advice of a qualified professional for your individual situation.

Hypothetical examples shown are for illustrative purposes only.

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