In years characterized by significant stock losses from almost everyone's portfolio, there's at least the small comfort of 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. To get the maximum tax benefit, you must strategically deduct losses in the most tax-efficient way possible.
- Realized capital losses from stocks can be used to reduce your tax bill.
- You can use capital losses to offset capital gains during a taxable year, allowing you 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.
- To deduct your stock market losses, you have to fill out Form 8949 and Schedule D for your tax return.
- If you own stock that has become worthless because the company went bankrupt and was liquidated, then you can take a total capital loss on the stock.
Understanding Stock Losses
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. So, a stock loss only becomes a realized capital loss after you sell your shares. If you continue to hold onto the losing stock into the new tax year, that is, after Dec. 31, then it cannot be used to create a tax deduction for the old year.
Although the sale of any asset you own can create a capital gain or loss, for tax purposes, realized capital losses are used to reduce your tax bill only if the asset sold was owned for investment purposes.
Stocks fall within this definition, but not all assets do. For example, if you sell a coin collection for less than what you paid for it, that does not create a deductible capital loss. (Irritating, since if you sell the collection for a profit, the profit is taxable income.) Also, if the losses you experienced are in a tax-advantaged retirement account, such as a 401(k) or IRA, they are generally not deductible.
Determining Capital Losses
Capital losses are divided into two categories, in the same way as capital gains are either short-term and long-term. Short-term losses occur when the stock sold 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.
To calculate for income tax purposes, 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. The cost basis price—which refers to the fact it provides the basis from which any subsequent gains or losses are figured—of your stock shares 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. In that case, you need to adjust the cost basis in accord with the magnitude of the split. For example, a 2-to-1 stock split necessitates reducing the cost basis for each share by 50%.
Deducting Capital Losses
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.)
To deduct your stock market losses, you have to fill out Form 8949 and Schedule D for your tax return. (Schedule D is a relatively simple form, and will allow you to see how much you'll save. If you want more information from the IRS, read Publication 544). 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.
If you did not have any short-term capital gains for the year, then the net is a negative number equal to the total of your short-term capital losses.
On Part II of Form 8949, your net long-term capital gain or loss is calculated by subtracting any long-term capital losses from any long-term capital gains. The next step is to calculate the total net capital gain or loss from the result of 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. For example, if you have a net short-term capital loss of $2,000 and a net long-term capital gain of $3,000, then you are only liable for paying taxes on the overall net $1,000 capital gain.
If the total net figure between short- and long-term capital gains and losses is a negative number, representing an overall total capital loss, then that loss can be deducted from other reported taxable income, up to the maximum amount allowed by the Internal Revenue Service (IRS).
As of tax year 2022, as mentioned above, the maximum amount that can be deducted from your total income is $3,000 for someone whose tax filing status is single or married, filing jointly. (The fact that it's the same for one single person, but two married people, is known as the "marriage penalty.") For someone who is married but filing separately, the maximum deduction is $1,500.
If your net capital gains loss is more than the maximum amount, you may carry it forward to the next tax year. 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—for example, $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.
It is necessary to keep records of all your sales. That way, if you continue to deduct your capital loss for many years, you can prove to the IRS that you, in fact, had a loss totaling an amount far above the $3,000 threshold.
A Special Case: Bankrupt Companies
If you own stock that has become worthless because the company went bankrupt and was liquidated, then you can take a total capital loss on the stock. However, the IRS wants to know on what basis the value of the stock was determined as zero or worthless. Therefore, you should keep some kind of documentation of the zero value of the stock, as well as documentation of when it became worthless.
Basically, 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 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. To do so, 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.
For Losses, Short Term is Better
Since long-term capital losses are figured at the same lower tax rate as long-term capital gains, you get a larger net deduction for taking short-term capital losses. Therefore, if you have two stock investments showing roughly equal losses, one you have owned for several years and one you have owned for less than a year, you can choose to take both losses.
However, if you want to realize only one of the losses, selling the stock you've owned for under a year is more advantageous, since the capital loss is figured at the higher short-term capital gains tax rate.
It is generally better to take any capital losses in the year for which you are tax-liable for short-term gains, or 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
Do not try selling a stock right at the end of the year to get a tax deduction, and then buy it right back in the new year. If you sell a stock and then repurchase it within 30 days, the IRS considers this a "wash sale," and the sale is not recognized for tax purposes. You cannot 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 Tax Bracket
Your income tax bracket matters. For tax year 2022, if you are in the 10 or 12% tax bracket, you are not liable for any taxes on capital gains. Therefore, you do not have to worry about offsetting any such gains by taking capital losses. If you fall into that tax bracket and have stock losses to deduct, they will go against ordinary income.
The Bottom Line
Since you have to pay taxes on your stock market profits, it is important to know how to take advantage of stock investing losses. Losses can be a benefit if you owe taxes on any capital gains—plus, you can carry over losses you can't deduct to use in future years.
The most effective way you can use capital losses is to deduct them from your ordinary income. You almost certainly pay a higher tax rate on ordinary income than on 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. Also, 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.
Regardless of tax implications, 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. If you still believe the stock will ultimately come through for you, it is probably unwise to sell it just to get a tax deduction.
However, if you determine your original assessment of the stock was simply mistaken and do not expect it to ever become a profitable investment, then there is no reason to continue holding on when you could use the loss to obtain a tax break.