Investors can experience losses due to market conditions or through investment strategies like tax-loss harvesting. The Internal Revenue Service has tax laws that allow the use of short-term and long-term investment losses to offset capital gains. Familiarity with these rules will help tax filers avoid mistakes and maybe provide some tax savings against a federal income tax liability.
Capital Gains or Capital Losses?
Capital assets can be stocks, bonds, mutual funds, real estate, collectibles and many other kinds of property resulting in investment income. The IRS states that for tax purposes, capital gains and losses are determined by the amount of sale above or below the cost basis (often the purchase price paid) for the asset. The loss must be realized by the taxpayer before it can be deducted.
A short-term capital gain or short-term loss happens when the asset is owned and held for one year or less. Holding an asset for more than a year before selling becomes a long-term gain or loss. This can get confusing when it comes to mutual funds and other investments where both long- and short-term gains may be distributed. Most investment management companies follow a first-in, first-out (FIFO) method to maximize the holding period.
The long-term capital gains tax rate is 15 percent for incomes that fall within IRS thresholds and except for certain types of real estate, small business stock and collectibles. For incomes over the thresholds, capital gains can be taxed at 20 percent. Short-term capital gains are taxed at your income tax rate like ordinary income. Short-term gains tax rates currently fall between 10 to 37 percent, depending on your ordinary income tax rate. It is advisable to seek the guidance of a tax professional if you have investment income.
Can Short-Term Gains Offset Long-Term Losses?
Use IRS tax forms Schedule D and Form 8948 to calculate short-term vs. long-term gains or losses on a tax return. First, use capital losses to offset gains of the same type and find your net gain or loss. Start by subtracting the total of your short-term losses from your total short-term capital gains to find your net short-term gain or loss. Next, offset your long-term gains and losses. The benefit of reducing short-term gains first is that they are treated as ordinary taxable income.
When you have a net long-term capital loss, you can use it to offset a net short-term capital gain by subtracting the loss from the gain. For example, if you have a net long-term loss of $15,000 and a net short-term gain of $10,000, you can use $10,000 of the long-term loss to offset the short-term gain. This works in the opposite direction as well. That is, you have to use a net short-term capital loss to offset net long-term capital gains.
Are There Limits on Capital Losses?
Suppose you use a net long-term loss to offset all of your short-term gains and have a $5,000 net excess loss still left over. You may use up to $3,000 to offset other income toward your same-year tax bill. In this example, that still leaves $2,000 of net loss that you can’t use to offset anything, meaning you can’t use it as a tax deduction for the current tax year. However, any leftover capital losses, either short-term or long-term can still provide a tax benefit. They can be used as a capital loss carryover to future years and used to offset future income.
A specific activity the IRS disallows when harvesting losses is selling a security and immediately purchasing it again within 30 days. This loss cannot be deducted for a tax break because it runs afoul of the wash sale rule. In fact, you cannot even purchase substantially similar securities in that 30-day holding period without triggering the wash sale rule. Wash sales will be indicated on your brokerage statement 1099-B and cannot be deducted.
Hashaw Elkins is a financial services and tax professional, as well as a project management consultant. She has led projects across multiple industries and sectors, ranging from the Fortune Global 500 to international nongovernmental organizations. Hashaw holds an MBA in Real Estate and an MSci in Project Management. She is further certified in organizational change management, diversity management, and cross-cultural mediation.