Capital Loss
Posted on November 11, 2008
Filed Under Capital Gains and Losses, Federal Income Tax
A taxpayer can lighten his tax burden by using a capital loss to lower, perhaps even eliminate, a net capital gain. If the capital loss is larger than the capital gain, then a taxpayer can use the excess to reduce up to $3,000 of ordinary income ($1,500 for a married taxpayer filing separately). Next, if a capital loss remains after the capital loss deduction, the remainder can be carried forward to future tax years only if it is larger than the $3,000 maximum; to permit a taxpayer to transfer a smaller capital loss amount to future years would result in a double tax benefit. Finally, a carryforward retains its character as a long term capital loss or a short term capital loss.
Example 1: At the end of the year, Sally Davis, a single taxpayer, uses a $15,000 short-term capital loss to offset a $10,000 long-term capital gain. She then uses $3,000 of the remaining loss to reduce her ordinary income. Since the $2,000 capital loss that now remains is less than the maximum $3,000 capital loss deduction, she is not eligible for a capital loss carryforward.
In effect, the capital loss deduction creates a “phantom” capital gain (but not to exceed $3,000) a taxpayer can use to reduce ordinary income. Consistency, namely, double entry bookkeeping, demands that this year’s phantom capital gain be offset in the next. In short, to balance the books in this possible world, an offsetting entry in the successor year must be made, and it is this entry–a phantom reduction of long-term capital gain–that would produce a double tax benefit.
Example 2: Assume Davis’ long-term capital gain for the year is $5,000, not $10,000. First, she could use $5,000 of her $15,000 short-term capital loss to mark down the long-term capital gain to zero. Next, she could take full advantage of the capital loss deduction and lower her ordinary income by $3,000. Since the remaining $7,000 short-term capital loss ($15,000 - $5,000 - $3,000 = $7,000) is larger than the maximum $3,000 capital loss deduction, she is permitted to carry forward indefinitely $4,000 of the remainder ($7,000 - $3,000). Finally, the capital loss carryover would would retain its short-term character.
Like its capital gain counterpart, a capital loss is good only for capital assets–for the most part, assets other than inventory and stock in trade, receivables, and real and depreciable property used in a trade or business. I say “for the most part” because the income tax treatment of assets, capital and non-capital, is riddled with exceptions: click on capital asset for a full explanation.
Additional relevant articles on the concept of capital loss are listed below:
Many happy returns, Roger
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