Recognized Loss

What Is a Recognized Loss?

A recognized loss occurs when an investment or asset is sold for less than its purchase price. Recognized losses may be reported for income tax purposes and then carried over into future periods, reducing any capital gains tax an investor would have to pay on a recognized profit.

Key Takeaways

  • A recognized loss is when an investment or asset is sold for less than its purchase price.
  • If at the time of sale a capital loss is realized on the asset, this loss can be deducted from capital gains tax.
  • Recognized losses can also be applied to future years, enabling individuals and companies to reduce their tax bills in periods when they have more taxable income.
  • The Internal Revenue Service (IRS) may itself delay the tax impact of certain transactions.

How a Recognized Loss Works

When an individual or company buys a capital asset it is likely that its valuation will deviate over time, either rising or falling against the purchase price. Any fluctuations in perceived worth do not count as a profit or loss until it is disposed of. If at the time of sale a capital loss is realized on the asset, it is then possible to make a claim against it.

Recognized capital losses can be used for effective tax planning strategies. For example, if an investor has taxable capital gains for a given year of $10,500 and is able to recognize a loss on another investment for $2,500, this loss can be applied against the taxable capital gains. Under those circumstances, this investor's net taxable capital gains for the year would be $8,000, rather than $10,500.

Investment losses can be written off against investment gains or other income up to a certain limit each year, currently $3,000, and any amount in excess of this can be carried forward for use in future years.

Recognized losses can also be applied for up to a certain number of years. That means that if a company or individual has no taxable income in a given year, recognized losses may offset taxes on profits at a future date instead.

Tax-loss harvesting uses recognized capital losses to potentially offset or reduce taxable income, which is particularly useful to investors already planning to sell off an undesirable investment and replace it with a more attractive one in order to diversify or rebalance a portfolio. This may include selling off shares in a fund that has underperformed, or it might pertain to a real estate property that becomes burdensome.

Losses from the sale of personal-use property, such as a car or home, aren't tax deductible.

Recognized Loss vs. Realized Loss

It is important to distinguish "recognized losses" from realized losses, following the disposal of an investment or asset. Both terms get confused with one another, despite having different meanings. A realized loss is realized immediately after an investor completes a transaction but has no impact on their taxes. Only a recognized loss may be deducted from capital gains.

Most investment asset sales create both realized and recognized losses simultaneously—typically immediately following the transaction. The Internal Revenue Service (IRS) delays the tax impact of certain transactions, which are specifically listed in the tax code. If a sale has a delayed tax impact, it will create a realized loss but not a recognized loss. 

Special Considerations

One fairly common transaction that can create a realized, unrecognized loss is a like-kind exchange. These transactions, also known as a 1031 exchange or a Starker exchange, occur when two taxpayers exchange similar assets, such as trading two rental properties with each other.

In December 2017, new rules were introduced limiting like-kind exchanges to real estate. Previously the exchange of tangible and intangible assets between businesses was also permitted.

This technique may be used to usher in an intentional future loss when a taxpayer knowingly exchanges their property for one that is less valuable. However, the recognized capital loss would only kick in when the investor later sells off the new asset.

Article Sources
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  1. Internal Revenue Service. "Publication 544 (2020), Sales and Other Dispositions of Assets." Accessed Aug. 23, 2021.

  2. Internal Revenue Service. "Topic No. 409 Capital Gains and Losses." Accessed Aug. 23, 2021.

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