You must strategically deduct losses in the most tax-efficient way possible to get the maximum tax benefit in years that are characterized by significant stock losses from almost everyone's portfolios. There's at least a small comfort in knowing that these losses can help you reduce your overall income tax bill. But tax regulations make some approaches and timing more effective than others.
Key Takeaways
- Realized capital losses from stocks can be used to reduce your tax bill.
- You can use capital losses to offset capital gains during a tax year, allowing you to remove some income from your tax return.
- You can use a capital loss to offset ordinary income up to $3,000 per year If you don’t have capital gains to offset the loss.
- You must fill out Form 8949 and Schedule D with your tax return to deduct your stock market losses
- You can take a total capital loss on the stock if you own stock that has become worthless because the company went bankrupt and was liquidated.
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Understanding Stock Losses
Stock market losses are capital losses. They may also be referred to as capital gains losses. Conversely, stock market profits are capital gains.
According to U.S. tax law, the only capital gains or losses that can impact your income tax bill are "realized" capital gains or losses. Something becomes "realized" when you sell it. A stock loss only becomes a realized capital loss after you sell your shares. It can't be used to create a tax deduction for the past year if you continue to hold on to the losing stock into the new tax year, after Dec. 31.
The sale of any asset you own can create a capital gain or loss for tax purposes, but realized capital losses are used to reduce your tax bill only if the asset you sold was owned for investment purposes.
Stocks fall within this definition, but not all assets do. It doesn't create a deductible capital loss if you sell a coin collection for less than what you paid for it. The profit is taxable income because you've sold the collection to earn a profit. Losses you experience in a tax-advantaged retirement account, such as a 401(k) or IRA, generally aren't deductible, either.
Determining Capital Losses
Capital losses are divided into two categories just as capital gains are either short-term or long-term.
Short-term losses occur when you are selling an investment that has been held for less than a year. Long-term losses happen when the stock has been held for a year or more. This is an important distinction because losses (and gains) are treated differently depending on whether they're short- or long-term.
The amount of your capital loss for any stock investment is equal to the number of shares sold, times the per-share adjusted cost basis, minus the total sale price. Cost basis price refers to the fact that it provides the basis from which any subsequent gains or losses are calculated. Your cost basis price is the total of the purchase price plus any fees, such as brokerage fees or commissions.
The cost basis price has to be adjusted if there was a stock split during the time you owned the stock. You must adjust the cost basis by the magnitude of the split in this case. A 2-to-1 stock split would necessitate reducing the cost basis for each share by 50%.
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Deducting Capital Losses
"You can use capital losses (stock losses) to offset capital gains during a taxable year," saysCFP®, AIF®, CLU® Danile Zajac of the Zajac Group. "By doing so, you may be able to remove some income from your tax return.If you don’t have capital gains to offset the capital loss, you can use a capital loss as an offset to ordinary income, up to $3,000 per year. If you have more than $3,000, it will be carried forward to future tax years." Here are the steps to take when it comes to tax filing season.
Step 1. Calculate Your Short-Term and Long-Term Capital Gains and Losses
You must fill out Form 8949 and Schedule D with your tax return to deduct your stock market losses. Schedule D is a relatively simple form and it will allow you to see how much you'll save. (Read Publication 544 if you want more information from the IRS.) Short-term capital losses are calculated against short-term capital gains, if any, on Part I of Form 8949 to arrive at the net short-term capital gain or loss.
The net is a negative number equal to the total of your short-term capital losses if you didn't have any short-term capital gains for the year.
Your net long-term capital gain or loss is calculated on Part II of Form 8949 by subtracting any long-term capital losses from any long-term capital gains.
Step 2. Calculate Your Total Net Capital Gain or Loss
The next step is to calculate the total net capital gain or loss which results from combining the short-term capital gain or loss and the long-term capital gain or loss.
That figure is entered on the Schedule D form. You're only liable for paying taxes on the overall net $1,000 capital gain if you have a net short-term capital loss of $2,000 and a net long-term capital gain of $3,000. Investors often asses their capital gains and losses at the end of the year for tax planning purposes and may sell off under-performing assets at a loss in order to offset gains from other securities, a practice known as tax loss harvesting.
Step 3. Use an Overall Loss to Offset Taxable Income
A loss can be deducted from other reported taxable income up to the maximum amount allowed by the Internal Revenue Service (IRS) if the total net figure between short- and long-term capital gains and losses is a negative number, representing an overall total capital loss.
You can deduct capital losses up to the amount of your capital gains plus $3,000 if your tax filing status is single or married filing jointly as of tax year 2023. Someone who is married but filing separately can deduct capital losses up to the amount of their capital gains plus $1,500.
Step 4. Carry Forward a Loss
You may carry forward a loss to the next tax year if your net capital gains loss is more than the maximum amount. The amount of loss that was not deducted in the previous year, over the limit, can be applied against the following year's capital gains and taxable income. The remainder of a very large loss such as $20,000 could be carried forward to subsequent tax years and applied up to the maximum deductible amount each year until the total loss is applied.
Using capital losses in this way can give you a tax break, potentially for a number of years. If you need help in determining the best way to balance your capital gains and losses, it may be advisable to consult a financial advisor.
Keep records of all your sales so you can prove to the IRS that you did indeed have a loss totaling an amount far above the $3,000 threshold if you continue to deduct your capital loss for many years.
A Special Case: Bankrupt Companies
You can take a total capital loss on the stock if you own stock that has become worthless because the company went bankrupt and was liquidated. But the IRS wants to know on what basis the value of the stock was determined as zero or worthless. You should keep some kind of documentation of the zero value of the stock, as well as documentation of when it became worthless.
Any documentation that shows the impossibility of the stock offering any positive return is sufficient. Acceptable documentation shows the nonexistence of the company, canceled stock certificates, or evidence the stock is no longer traded anywhere. Some companies that go bankrupt allow you to sell them back their stock for a penny. This proves you have no further equity interest in the company and it documents what is essentially a total loss.
Considerations in Deducting Stock Losses
Always attempt to take your tax-deductible stock losses in the most tax-efficient way possible to get the maximum tax benefit. Think about the tax implications of various losses you might be able to deduct. As with all deductions, it's important to be familiar with any laws or regulations that might exempt you from being eligible to use that deduction, as well as any loopholes that could benefit you.
Short Term Is Better for Losses
Long-term capital losses are calculated at the same lower tax rate as long-term capital gains so you get a larger net deduction for taking short-term capital losses.
You could choose to take both losses if you have two stock investments showing roughly equal losses, one that you've owned for several years and one you've owned for less than a year. But selling the stock you've owned for under a year is more advantageous if you want to realize only one of the losses because the capital loss is figured at the higher short-term capital gains tax rate.
It's generally better to take any capital losses in the year for which you are tax-liable for short-term gains, or in a year in which you have zero capital gains because that results in savings on your total ordinary income tax rate.
Know the "Wash Sale" Rule
Don't try selling a stock at the end of the year to get a tax deduction and buy it right back in the new year. The IRS considers this a "wash sale" if you sell a stock and then repurchase it within 30 days and the sale isn't recognized for tax purposes. And you can't deduct capital losses if you sold the stock to a relative. This is to discourage families from taking advantage of the capital loss deduction.
Pay Attention to Your Overall Income
Short-term capital gains are taxed at ordinary income tax rates but long-term capital gains are taxed at their own lower tax rates. You'll pay a 0% tax rate on any long-term gains you realize in 2024 if you're single and your income is less than $47,025 in that year. This increases to $94,050 if you're married and filing a joint return.
You therefore wouldn't have to worry about offsetting any such gains by taking capital losses. They'll go against your ordinary income if you have any stock losses to deduct.
How Do I Deduct Stock Losses on My Tax Return?
You must fill out IRS Form 8949 and Schedule D to deduct stock losses on your taxes. Short-term capital losses are calculated against short-term capital gains to arrive at the net short-term capital gain or loss on Part I of the form. Your net long-term capital gain or loss is calculated by subtracting any long-term capital losses from any long-term capital gains on Part II.
You can then calculate the total net capital gain or loss by combining your short-term and long-term capital gain or loss.
How Much of a Stock Loss Can You Write Off?
The IRS allows you to deduct stock losses up to the amount of your capital gains plus $3,000 if you are a single filer or married filing jointly. You can deduct up to the amount of your capital gains plus $1,500 if you're married and filing a separate return.
Are Stock Losses 100% Tax Deductible?
You may only deduct 100% of your stock losses if the losses stem from a company that went bankrupt so the stock is now worthless. You can't deduct 100% of the losses if there's any possibility of the stock having a positive value in the future.
Do Stock Losses Offset Income?
You can deduct stock losses from other reported taxable income up to the maximum amount allowed by the IRS—up to $3,000 a year—if you have no capital gains to offset your capital losses or if the total net figure between your short- and long-term capital gains and losses is a negative number, representing an overall capital loss.
The Bottom Line
You have to pay taxes on your stock market profits so it's important to know how to take advantage of stock investing losses.Losses can benefit you if you owe taxes on any capital gains and you can carry over losses you can't deduct to use in future years.
The most effective way to use capital losses is to deduct them from your ordinary income. You almost certainly pay a higher tax rate on ordinary income than on long-term capital gains so it makes more sense to deduct those losses against it.
It’s also beneficial to deduct them against short-term gains which have a much higher tax rate than long-term capital gains. Your short-term capital loss must first offset a short-term capital gain before it can be used to offset a long-term capital gain.
The bottom line on whether you should sell a losing stock investment and realize the loss should be determined by whether, after careful analysis, you expect the stock to return to profitability. It's probably unwise to sell it just to get a tax deduction if you believe that the stock will ultimately come through for you.
