Capital Loss Carryover: Definition, Rules, and Example

What Is a Capital Loss Carryover?

Capital loss carryover is the net amount of capital losses eligible to be carried forward into future tax years. Net capital losses (the amount that total capital losses exceed total capital gains) can only be deducted up to a maximum of $3,000 in a tax year. Net capital losses exceeding the $3,000 threshold may be carried forward to future tax years until exhausted. There is no limit to the number of years there might be a capital loss carryover.

Understanding Capital Loss Carryover

Capital loss carryovers allow a taxpayer to capture losses from one period to be used in a future period income tax filing. Capital loss tax provisions lessen the severity of the impact caused by investment losses. However, the provisions do not come without exceptions. Investors must be careful of wash sale provisions, which prohibit repurchasing an investment within 30 days of selling it for a loss. If this occurs, the capital loss cannot be applied toward tax calculations and is instead added to the cost basis of the new position, lessening the impact of future capital gains.

Tax-Loss Harvesting

Tax-loss harvesting provides a mean of improving the after-tax return on taxable investments. It is the practice of selling securities at a loss and using those losses to offset taxes from gains from other investments and income. Depending on how much loss is harvested, losses can be carried over to offset gains in future years. Tax-loss harvesting often occurs in December, with December 31 being the last day to realize a capital loss.

Taxable investment accounts identify realized gains generated for the year, so the investor seeks to find unrealized losses to offset those gains. Doing so allows the investor to avoid paying as much in capital gains tax. If the investor wants to repurchase the same investment, they must wait 31 days to avoid a wash sale.

For example, suppose a taxable account currently has $10,000 of realized gains that were incurred during the calendar year, yet, within its portfolio is ABC Corp stock with an unrealized loss of $9,000. The investor may decide to sell the stock prior to the end of the year in order to realize the loss. If the ABC Corp stock was sold on or prior to December 31, the investor would realize $1,000 ($10,000 gains - $9,000 ABC Corp loss) in capital gains. Abiding by the wash-sale rule, if the stock was sold on December 31, the investor would need to wait until January 31 to repurchase it.

Advantages and Disadvantages of Capital Loss Carryover

Pros of Capital Loss Carryover

The potential for tax savings is the main benefits of capital loss carryovers. You can lower your overall taxable income by using capital losses from prior years to offset capital gains in subsequent years by carrying those losses forward. Your tax liability may decrease as a result, and maybe your highest tax rate as well.

Capital loss carryovers provide you the freedom to choose when to use your losses. Depending on your unique tax planning requirements, you can decide when to use the carryover to offset future capital gains. In a year when you expect to have more capital gains or when your tax bracket is higher, for instance, you can strategically opt to employ the carryover. Since capital loss carryovers may be carried forward indefinitely, you can also potentially improve your overall tax situation and manage your tax liabilities over time.

Carryovers of capital losses might also be helpful when planning your investment strategy. You can reduce the total tax impact of your investing activities if you experience sizable capital losses in a single asset class or investment by offsetting those losses against capital gains from other investments. For this reason, you may be more inclined to make riskier investments knowing there are potential tax benefits that may help you offset high gains in other areas.

Last, carryovers of capital losses may be carried forward even after death which may be advantageous to your heirs and estate. You can transfer unused capital loss carryovers to your estate so that your estate or beneficiaries can use them in subsequent tax years.

Cons of Capital Loss Carryover

The total amount of capital losses that may be written off in a single tax year is subject to restrictions. Beyond these thresholds, all excess losses must be carried over to subsequent years. This implies that it might take several years to use up a sizable capital loss carryover.

As is the case with any type of legislation, both tax laws and regulations are subject to change. Although capital loss carryovers are typically permitted, future tax law changes could impose limitations or change the regulations governing their use. Long-term tax planning that relies on carryovers may be more difficult as a result of this uncertainty.

Carryovers of capital losses may only be applied to offset capital gains. You can't use your carryover losses to lower your tax bill if you don't have capital gains in a certain tax year. The inability to use carryovers effectively due to this timing restriction may result in a longer period of time before tax benefits are realized. This also further restricts when this tax advantage can actually be used.

There is somewhat of an administrative burden to consider with capital loss carryovers. You must keep correct records and documentation in order to support your capital losses and carryovers. This comprises the cost basis details, purchase and sell transaction records, and any changes made to determine the losses. This information may take years to materialize, requiring documentation every step of the way.

When to Realize and Claim a Capital Loss Carryover

To begin offsetting within the same tax year, you must subtract any capital losses from any capital gains you have in the year in question. Accordingly, if you have both capital gains and losses in a given year, you should use the losses to reduce or completely wipe out your taxable capital gains for that year. If your capital losses for the year are greater than your capital profits, you can carry the unused losses forward to subsequent tax years.

In those subsequent years, you can claim a capital loss carryover when you have capital losses that exceed your capital gains in that given tax year. In general, you can carry capital losses forward indefinitely, either until you use them all up or until they run out. Carryovers of capital losses have no time limit, so you can use them to offset capital gains in subsequent tax years until they are exhausted.

Keep in mind there may be restrictions on how much of a loss you can claim in a given tax year, even though you can carry over capital losses. Beyond these limits, any excess losses may be carried over to subsequent years.

How to Realize and Claim a Capital Loss Carryover

To claim a capital loss carryover, you first need to figure out what that carryover amount will be. Figure out the entire amount of capital losses from prior tax years that you are eligible to carry forward. When your capital losses have been neutralized against capital gains from prior years, this should be the remaining amount.

To record your capital gains and losses in your current year tax return, use Schedule D (Capital Gains and Losses) on Form 1040 of your tax return. Give the essential details regarding the sales or disposal of assets such as the dates of purchase and sale, the amount of the revenues, and the assets' cost or basis.

For any spreadsheets or specific parts pertaining to capital loss carryovers, refer to the instructions included with Schedule D. These instructions normally walk you through the process of calculating the carryover amount and assist you in determining the tax deduction that can be claimed. This worksheet is discussed more in depth in the following section.

As soon as you have calculated the amount of the capital loss carryover, transfer that amount to the correct line on your tax return. This may differ based on the exact tax form you are utilizing and the IRS guidelines provided for that specific tax year; refer to the tax form's instructions for the specific lines.

It's important to keep accurate records and documentation of your capital losses and carryovers, including any evidence that the initial losses and carryover computations were made correctly. This will be helpful if the IRS audits you or if you need to refer to the data for upcoming tax years.

Capital Loss Carryover Worksheet

To keep track of capital loss carryovers, the IRS provides a worksheet or form within the Schedule D instructions. This worksheet typically helps you calculate and document the amount of capital loss that you can carry over from one tax year to the next. It may involve calculations based on the specific details of your capital gains and losses, such as the type of assets sold, the holding period, and any applicable limitations or adjustments.

A similar type of worksheet is also provided within Publication 550 (Investment Income and Expenses). Be mindful to always review the most recent year's worksheet, as changes in legislation may change the calculations that impact the amount of carryover you're permitted to take.

Example of Capital Loss Carryover

Any excess capital losses can be used to offset future gains and ordinary income. Using the same example, if ABC Corp stock had a $20,000 loss instead of $9,000 loss, the investor would be able to carry over the difference to future tax years. The initial $10,000 of realized capital gain would be offset, and the investor would incur no capital gains tax for the year. In addition, $3,000 can be used to reduce ordinary income during the same calendar year.

After the $10,000 capital gain offset and the $3,000 ordinary income offset, the investor would have $7,000 of capital losses to carry forward into future years. Carrying losses forward is not restricted to the following tax year. Losses can be carried forward into future years until exhausted.

The Bottom Line

A capital loss carryforward refers to the ability to offset capital gains in future tax years with unused capital losses from previous years. When an individual or business incurs capital losses that exceed their capital gains in a given tax year, the excess losses can be carried forward to future years. This allows taxpayers to utilize the losses in subsequent years, reducing their taxable income and potentially lowering their overall tax liability.