Declining share prices and losses from stock sales may cause difficulties across a range of circumstances, but U.S. tax law provides some relief in the form of deductions that can significantly reduce investors' tax bills. Capital losses happen when investors sell stock for less than they paid, including expenses such as commissions. A taxable loss can only be taken once the stock is sold. If capital gains occur elsewhere in a given portfolio, losses may be used to offset the taxes on those profits and can even reduce taxes on regular income.
Short-term capital gains are taxed at the same rate as regular income, which is the maximum rate that an investor must pay. The tax code thus provides a strong incentive to take short-term losses to offset those gains. While no investor wants to take losses, they are inevitable over time in diversified portfolios. This question becomes particularly pressing toward the end of the year, when investors must weigh their individual stock holdings and make key decisions by December 31 that will be reflected in their returns due by April 15 of the following year.
Long-term gains fare much better and are taxed at a maximum rate of 15 percent. For lower-income taxpayers, the rate can fall to zero. Long-term losses, those that are booked after at least one year, can offset those gains. Schedule D of IRS Form 1040 breaks down the long-term profit or loss, which is then combined with short-term trades to figure the net amount due or the total allowable deduction. A long-term loss of $10,000, for example, may be used to offset a $12,000 short-term gain, leaving $2,000 as a capital gain.
Investors left with a net capital loss for the year may deduct up to $3,000 to offset the tax due on other income. If an individual earns $50,000 during the year but suffers a $2,000 loss on the sale of stock, he will base his tax bill on a $48,000 income. All normal deductions will still apply.
For net losses greater than $3,000, after including any offsetting gains, investors may carry those amounts over to future years to apply both toward capital gains and regular income. Stockholders should thus keep detailed records of all such losses, because a particularly large loss 10 years ago can still be used to reduce present-day tax bills. While such tax considerations remain important as part of a disciplined investment strategy, the viability of the underlying stock should always be the prime consideration when making buy and sell decisions.