This article/post contains references to products or services from one or more of our advertisers or partners. We may receive compensation when you click on links to those products or services
Nobody likes losing money, but it happens—especially in investing. Even the savviest investors aren’t always right all the time. Although it is disheartening to sell at a loss, smart investors know when to cut their losses when investments don’t pan out. But worry not: your efforts don’t have to be completely wasted, no matter how low an investment tumbles. Capital losses are perhaps the silver lining when losing money. In fact, realizing your capital losses can also be a strategic tax reason to sell your losing investments.
What Is a Capital Loss?
When you sell a capital asset for less than what you paid for it, you have incurred what is known as a capital loss. Common capital assets include stocks, bonds, mutual funds, homes, and cars. Capital loss isn’t the same thing as value depreciation—the loss has to be realized in order to be considered a capital loss. For example, if the value of a stock you own drops below your purchase price, you will not incur a capital loss unless you sell at that lower price.
There are two important capital loss categories:
Long Term Capital Loss — Losses realized from the sale of investments owned for over one year.
Short Term Capital Loss — Losses realized from the sale of investments owned for less than one year.
Capital gains are taxed as ordinary income, while long-term capital gains have a lower tax rate. It’s important to keep this in mind when calculating your net capital gains and losses for the tax year.
How to Calculate a Capital Loss
Calculating capital losses is fairly simple. You subtract the sale value of your investment from your purchase price. If your cost basis for a stock position is $10,000 and your sale price is $7,000, the capital loss is $3,000.
Short-term capital gains must be netted against short-term capital losses and long-term capital gains against long-term losses before they are netted against each other.
Capital losses are typically used to offset taxes that must be paid on capital gains. However, if your capital losses exceed your capital gains, you can use your capital losses to lower your total taxable income up to $3,000 annually. Capital losses that exceed $3,000 can typically be carried over indefinitely.
In order to report capital gains and capital losses to the IRS, you typically need two forms:
- Form 8949 — For “Sales and Other Dispositions of Capital Assets”. This form is used to report net gains and losses from investment assets.
- Form 1040 — The net number from Form 8949 is transferred to Schedule D on the Individual Income Tax Return form 1040.
How Do You Use Capital Losses to Offset Capital Gains?
Strategically using capital losses to offset capital gains is known as tax loss harvesting. If you have a capital gain in a certain year, you can realize a capital loss to offset that gain. However, you must use short-term capital losses to offset short-term capital gains before you can net them against long-term capital gains or losses.
Short-term capital gains are taxed as ordinary income while long-term capital gains are taxed at a more generous rate. For example, the top federal marginal income tax rate in 2021 was 37%, while the top federal long-term capital gains tax rate was 20%. Since long-term capital gains have a more favorable tax rate, using short-term capital losses to offset long-term capital gains may not always be a wise strategic decision.
Examples of How Capital Loss Works
Imagine you purchase 1,000 shares of ABC company stock at $10 per share, a total investment of $10,000. The stock price drops to $7 a share. Meanwhile, your 1,000 shares of XYZ company stock have risen from $10 to $12.
You sell ABC company for a total of $7,000, incurring a $3,000 capital loss. You then sell XYZ stock for $12,000—a $2,000 capital gain. Your capital losses will offset your capital gains, and you can use the remaining $1,000 in capital losses to lower your total taxable income.
Let’s imagine that scenario a little differently. You sell ABC stock for a total $9,000—a $1,000 capital loss—but you still sell XYZ stock for a $2,000 capital gain. This leaves you with a total $1,000 capital gain.
How to File and Claim Losses
The first step to filing and claiming losses is to determine whether you had a net capital gain or loss for the year. To do this you must net losses and gains of the same type against each other. In other words, short-term capital gains are netted against short-term capital losses, and long-term capital gains against long-term capital losses.
For example, let’s imagine that your capital gains and losses for the year look like this:
Short-terms gains: $5,000
Long-term gains: $3,000
Short-term losses: $2,000
Long-term losses: $5,000
Netting short-terms gains against losses we arrive at a net gain of $3,000 ($5,000 ST gain – $2,000 ST loss). Netting long-term gains against loss we arrive at a net loss of $2,000 ($3,000 LT gain – $5,000 LT loss).
Now that we have our net capital loss or gain in each category, we can calculate our net gain/loss by netting the categories against each other. Taking the short-term gain of $3,000 and subtracting the long-term loss of $2,000, we arrive at a $1,000 net short-term gain.
Let’s say your annual ordinary income is $50,000 and you are single. You would pay a rate of 22% on your $1,000 short-term gain. Had you managed to strategically position yourself for a long-term capital gain you would have only had to pay a rate of 15%.
Once you’ve calculated your net, you must download and fill out Form 8949 from the Internal Revenue Service. This can be a meticulous process if you are a busy trader. Luckily, most tax software allows you to import data directly from your broker. Alternatively, you can just hire a CPA to take care of all of it for you.
What is the Wash-Sale Rule?
Many amateur traders have liquidated a losing position with a capital loss strategy in mind, only to purchase the same security back too soon and lose their tax benefit. Learning about the IRS wash-sale rule the hard way is an unpleasant surprise, so it’s important to understand it before you start selling losing positions.
When you liquidate a position you have to wait at least 30 days from the date of sale before you repurchase the security, otherwise the IRS wash-sale rule stipulates that you can’t deduct that loss on your tax return and your losses would be deferred.
This makes tax loss harvesting a bit more complicated for investors who like to trade stocks regularly. If you sell a stock at a loss only to want to buy it again within 30 days, you won’t be able to purchase it without activating the wash-sale rule.
Let’s look at an example of the wash-sale rule in action. Imagine you own 100 shares of XYZ company stock with a cost basis of $3,000. On June 21st you sell those 100 shares for $2,000. Then on June 28th you buy back 100 shares at $600. This would trigger the wash-sale rule, preventing you from capitalizing on the $1,000 capital loss.
It’s definitely worth taking the time to understand how capital losses work and how to use them. Efficiently utilizing your capital losses will enable you to minimize your taxable capital gain.
Tax-loss harvesting strategy is an excellent way to eject investments that you want out of your portfolio due to poor performance. Even if you don’t have substantial capital gains for the tax year, you can still use capital losses to lower your income tax liability.
When considering capital losses as part of your investment strategy, it’s also important to keep in mind that long-term capital gains/losses are taxed at more favorable rates than short-term capital gains/ losses. Additionally, be mindful of the IRS wash sale rule when you are trying to realize capital losses. These are all important factors to help you maximize the use of your capital losses.
Disclaimer: The content presented is for informational purposes only and does not constitute financial, investment, tax, legal, or professional advice. If any securities were mentioned in the content, the author may hold positions in the mentioned securities. The content is provided ‘as is’ without any representations or warranties, express or implied.