Declaring losses on tax returns is one way for investors to offset capital gains. Reducing capital gains in this way reduces the investor’s potential tax bill. But there are certain rules to follow, and not all losses can be deducted for the current year.
3K Capital Loss Rule
A capital gain or loss is generated from the difference between an asset’s adjusted basis and the amount realized from the sale.
The IRS allows investors to deduct up to $3,000 in capital losses per year. The $3,000 loss limit is the amount that can go against ordinary income. Above $3,000 is where things can get a little complicated. The $3,000 loss limit rule can be found in IRC Section 1211(b).
For investors who have more than $3,000 in capital losses, the remaining amount can’t be used toward the current tax year. Instead, it is used to offset gains in future years but only at $3,000 per year.
What happens if an investor has $10,000 in capital gains and $6,000 in capital losses? Can they only deduct $3,000 in losses? This is where some investors get a bit confused about how the loss rule works.
The above example shows a net $4,000 gain and no net loss. The $3,000 loss rule only applies to a net loss. That means the loss must be more than the gain before the rule comes into play.
Note that this rule doesn’t apply to qualified retirement accounts such as an IRS, 401(k), 403(b), or 457. It does apply to taxable accounts.
What Is a Capital Gain/Loss?
Capital gains and losses are created from selling capital assets. So what is a capital asset?
Unfortunately, the IRS never really gives us a clear definition of what a capital asset is. Instead, it states: “Almost everything you own and use for personal or investment purposes is a capital asset.”
Capital assets include stocks, investment properties, and primary residences. Some assets do not qualify as capital assets. It’s best to work with an accountant if you have concerns about the tax implications of selling an asset.
Example of a Capital Loss
We’ll walk through an example using an investor who sold stock for a loss. The investor bought 100 shares of stock at $50/share. That’s a total of $5,000. The investor sold the stock for $45 a share for a loss of ($5000 - $4500) $500. The $500 loss can be deducted against ordinary income in the current tax year if there are no capital gains to offset.
Using another example, this investor has a larger loss. They buy 1,000 shares of stock at $50/share. They then sell it at $45 for a loss of $5,000. The investor cannot deduct the full $5,000 against ordinary income, assuming there are no other capital gains to offset. Instead, the first $3,000 can be deducted from ordinary income. The remaining $2,000 is not invalid or lost. It is a capital loss carried forward, which means it carries over into future tax years.
If the investor has no capital losses/gains in the next tax year, the carried $2,000 can be applied to that year’s ordinary income, potentially reducing the investor’s tax bill.
We touched on the next example in a previous section, but what happens if an investor has the following realized amounts:
Stock A transactions: +$15,000
Stock B transactions: -$5,000
The net realized amount is +$10,000. Because there is no net loss, the $3,000 loss rule doesn’t apply. However, if the investor instead has these two transactions:
Stock A transactions: -$15,000
Stock B transactions: +$5,000
Then the net realized amount is -$10,000, and the $3,000 loss rule comes into play. In this case, the investor can deduct the $3,000 capital loss in the current tax year and carry forward $7,000.
Related Tax Forms
Sales of stock are reported on Form 8949 (Sales and Other Dispositions). Totals from that form flow to Schedule D (Capital Gains and Losses). Schedule D gains/losses then flow to Form 1040.
Calculating realized amounts can get complex, especially when ensuring the correct adjusted basis is used. That’s why working with an account is important when figuring out capital gains and losses and any potential carry forward losses.
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.