In the United States, the Internal Revenue Code allows taxpayers to deduct losses from both long term and short term capital gains against other sources of income. However, the ability to deduct, or offset, capital gain losses against income is subject to a number of limitations and aggregation rules.
Under the Internal Revenue Code, capital losses can not be used to reduce the amount of income from other sources until the losses are realized. For a loss to become realized, the risks and rewards of owning the capital asset must no longer inure to the individual income taxpayer. Typically, a loss becomes realized through the outright sale of the asset. After realization of the loss, capital assets must be grouped by holding period. Those assets that were held by the taxpayer for a year or less are considered short-term capital losses and those assets that were held by taxpayer for more than a year are considered long-term capital losses.
Taxpayers must first use any long-term capital losses to offset the amount of any long-term capital gain. After this offset is considered, any remaining loss is considered a net long-term capital loss. Similarly, taxpayers must first use any short-term capital losses to offset the amount of any short term capital gain, and -- after offset -- any remaining loss is considered a net short-term capital loss. Any net long-term capital loss must then be used to offset any net short-term capital gain, and vice-versa, any net short-term capital loss must be then used to offset any net long-term capital gain. Any remaining loss is the taxpayer's net capital loss for the tax year.
Deduction Against Ordinary Income
Any remaining net capital loss for the tax year may then be used to offset any other ordinary income of the taxpayer, including salary and wage income, interest or dividend income, and other miscellaneous income. Under the Internal Revenue Code, the annual deduction against ordinary income, however, is limited to $3,000 per taxpayer annually. Taxpayers with net capital losses in excess of $3,000 may carry-forward the unclaimed loss deduction to future tax periods. In future tax periods, the amount of unrealized loss deduction carried-forward is then compared against net capital gains or losses generated in that income tax period and any net capital loss is again subject to the same $3,000 annual limitation and carry-forward provisions.
The Internal Revenue Service (IRS) requires taxpayers to report capital losses on Schedule D, Capital Gains and Losses, to IRS Form 1040, U.S. Individual Income Tax Return. Taxpayers use Schedule D to report, separately, each capital gain or loss incurred during the period and to perform the aggregation and netting computations described earlier. The net capital gain or loss is then carried forward to page 1 of Form 1040 (subject to the $3,000 loss limitation), where it becomes a component of the taxpayer's adjusted gross income for the tax year and, ultimately, a component of the taxpayer's taxable income.
Michael Dreiser started writing professionally in 2010. He is a certified public accountant with experience working for a large New York City accountancy and expertise in areas ranging from private equity taxation to investment management. He holds a Master of Business Administration in international finance from l’École Nationale des Ponts et Chaussées in Paris.