Capital Loss Deduction: Tax Season Basics for Investors

Tax season can be an annual exercise in keeping score financially. It’s a time when investors tally up their winners and their losers for the ultimate commissioner— the Internal Revenue Service (IRS). And that’s where capital gains and capital losses come in. Many investors are surely familiar with capital gains, but what is a capital loss? Capital losses are just as important to understand and account for at tax time.

A capital loss typically stems from a financial loss from the sale of a capital asset such as real estate, mutual funds, bonds, or stock shares. A capital loss deduction can offset capital gains and reduce tax liability, although there are limitations and important factors to consider such as short- versus long-term losses, “wash” sales, and more.

Let’s look at some basic questions about capital losses for taxpayers.

What defines a capital asset that may qualify for a capital loss deduction?

According to the IRS, many of the things people own and use for personal or investment purposes can be considered capital assets. Examples include a home or stocks and bonds. Inherited property may also be a capital asset.

When a capital asset is sold, a capital gain or loss is determined by calculating the difference between the adjusted “basis” (typically, what the owner paid for the asset) and the sale price. If you received the asset as a gift or inheritance, different basis rules apply.

How do I know whether I can take a capital loss deduction?

Know your limits and your time frames. Losses on investments are first used to offset capital gains of the same type, meaning short-term losses are first deducted against short-term gains, and long-term losses are deducted against long-term gains. Net losses of either type can then be deducted against the other kind of gain.

Here’s an example from Intuit TurboTax: If you have a $2,000 short-term loss and a $1,000 short-term gain in one calendar year, the net $1,000 short-term loss can be deducted against your net long-term gain (assuming you have one).

If you have an overall net capital loss for the year, you can deduct up to $3,000 of that loss against other kinds of income, including your salary and interest income. Any excess net capital loss can be carried over to subsequent years to be deducted against capital gains and against up to $3,000 of other kinds of income. (For those married filing separately, the annual net capital loss deduction limit is only $1,500.)

What’s the difference between a short-term capital loss and a long-term capital loss?

Short-term losses arise from the sale of assets owned one year or less; long-term losses come from the sale of assets held longer than one year. Short-term gains are taxed at your maximum tax rate, which was as high as 37% in 2022, while most long-term gains are taxed at either zero, 15%, or 20% for 2022.

If the asset is a gift or inheritance, certain exceptions apply. To determine how long you held the asset, you’d generally count from the day after you acquired the asset up to and including the day you disposed of the asset, according to IRS.gov.

How does the wash sale rule work?

Suppose you have a capital loss that you’d like to report for tax purposes, but you still see some long-term upside and don’t really want to exit your position. So you sell the asset at the end of the year and then buy it right back after the New Year’s party, right? Wrong. That’s a wash sale, and IRS rules prohibit you from claiming a deduction.

According to IRS.gov, a wash sale occurs when you sell or trade stock or securities at a loss, and within 30 days before or after the sale, you do any of the following:

• Buy “substantially identical” stock or securities
• Acquire substantially identical stock or securities in a fully taxable trade
• Acquire a contract or option to buy substantially identical stock or securities
• Acquire substantially identical stock for your Individual Retirement Account (IRA) or Roth IRA

For example, suppose an investor buys 100 shares of a stock for $1,000, sells those shares for $750, and within 30 days of the sale, buys 100 shares of the same stock for $800. Because the investor bought “substantially identical” stock, the loss of $250 is not tax deductible. However, the investor can add that disallowed loss ($250) to the cost of the new stock and establish the basis at $1,050.

If you purchase and sell stock at a loss within 30 days but don’t purchase or acquire substantially identical stock or securities, you have a short-term capital loss as opposed to a wash sale.

What IRS forms do I need to report capital losses or capital gains?

Taxpayers must generally file Form 8949, Sales and Other Dispositions of Capital Assets and Schedule D, Capital Gains and Losses with their tax returns to report capital gains and losses.

Have more questions about deducting capital losses? Seek advice from a professional tax accountant.

TD Ameritrade does not provide tax advice. We suggest you consult with a tax-planning professional with regard to your personal circumstances.