We often receive questions about the tax treatment of capital gains and losses, we’ve provided the following summary to offer some clarity on the topic:
For context, a “capital gain” is a type of income that is generated when an investment is sold for a price higher than its cost. Conversely, a capital loss, which is potentially tax deductible, is created when an investment is sold for less than its cost. For example, if a stock was purchased for $100 and later sold for $120, the capital gain would be $20. Instead, if a stock was purchased for $100 and later sold for $90, the capital loss would be $10.
The amount of tax due on a capital gain will be impacted by the taxpayer’s “holding period”, which is the length of time between the purchase date and sale date. “Long-term” gains and losses are from the sales of assets held longer than one year. “Short-term” gains and losses are from sales of assets held one year or less. Long-term gains are taxed at capital gains rates whereas short-term gains are taxed at ordinary income rates. Capital gains tax rates are lower than ordinary income tax rates, which means long-term investments receive more favorable tax treatment.
Netting Gains and Losses
When there are multiple sales within the same year, steps must be taken to determine the overall gain or loss. The first step is to separate the sales into long-term and short-term based on the holding period. The second step is to net the gains and losses against each other within each group. Long-term losses are netted against long-term gains and short-term losses are netted against short-term gains. This creates four possible scenarios:
- Long term is a net gain and short term is a net gain
- Long term is a net gain and short term is a net loss
- Long term is a net loss and short term is a net gain
- Long term is a net loss and short term is net loss
Scenario 1 – which only involves gains – is the simplest: the long-term net gain is taxed at capital gains rates and the short-term net gain is taxed at ordinary income rates. There is no deductible loss.
In Scenarios 2 and 3, the net gain and net loss from each group are netted against each other. For example, in Scenario 2, if the long-term net gain is $10,000 and the short-term net loss is ($2,000), then the taxable portion will be a long-term gain of $8,000. This will be taxed at capital gains rates because the holding period is long-term.
If the combined result under Scenario 2 or 3 is an overall net loss, then up to $3,000 of the loss is deductible against ordinary income in the current year. The loss limitation – which is always set at $3,000 – may prevent the taxpayer from deducting the full amount of the loss in the current year.
For example, in Scenario 3, if the long-term net loss is ($9,000) and the short-term net gain is $2,000, then the overall long-term net loss will be ($7,000). Of this loss, only ($3,000) will be deductible in the current year against ordinary income, and the remaining ($4,000) will be carried forward to the next year as a long-term capital loss. In the next year, the loss will be netted against long-term gains, if any, and one of the same four scenarios will be reached again. There is no limit to how many years a capital loss can be carried forward. When a loss is carried forward, it retains its identity as either long-term or short-term, so it can be placed in the correct group the following year.
In Scenario 4, the long-term and short-term groups both netted to losses. When the two groups are combined, they produce an even larger loss. For example, if the long-term net loss is ($4,500) and the short-term net loss is ($4,000), then the combined loss is ($8,500). Of this loss, ($3,000) is deductible against ordinary income in the current year. Short-term losses are always deducted first, so the ($3,000) will come from the short-term group. This means there will be a long-term loss carryforward of ($4,500) and a short-term loss carryforward of ($1,000).
Staying with this example, if there are no new sales in the second year, then an additional ($3,000) will be deductible against ordinary income. This will reduce the short-term loss carryover from ($1,000) to ($0) and the long-term loss carryover from ($4,500) to ($2,500). In the third year, assuming there are still no new sales, the remaining ($2,500) will be deductible against ordinary income.
For tax-planning purposes, it can be useful to strategically offset gains with losses in the current year. For example, if a taxpayer sells a stock for a gain of $20,000 early in the year and is holding a different stock with an unrealized loss of ($15,000) later in the year, then it may be prudent to sell the second stock and recognize the loss. If this is done, it will reduce the taxable gain from $20,000 to $5,000. Waiting until the following year to sell at a loss is less useful, as only ($3,000) of the ($15,000) loss will be deductible per year going forward (assuming no other sales occurred).
Another strategy is to isolate short-term gains and offset them with losses. For example, assume a taxpayer sells a stock for a $10,000 short-term gain early in the year. Toward the end of the year, he considers selling two other stocks that he has held long-term: one for a gain of $12,000 and the other for a loss of ($12,000). If he sells both in the current year, the long-term gain and loss will offset each other, and he will still be left with the short-term gain of $10,000. This gain will be taxed at ordinary income rates because it is short-term.
The taxpayer should instead consider selling only the long-term loss stock in the current year and postponing the sale of the long-term gain stock. If he sells only the long-term loss stock, then the ($12,000) long-term loss will fully offset the $10,000 short-term gain that he recognized earlier in the year. The remaining ($2,000) long-term loss will be fully deductible against ordinary income. In the following year (even as early as January), he could then sell the long-term gain stock and recognize the $12,000 gain. This gain will be taxed at capital gains rate because it is long-term. By isolating and offsetting the short-term gain in the current year, the taxpayer will effectively pay a lower tax rate on the overall capital gain income.
Please let us know if you would like to discuss tax planning or have any questions.
The information contained within this blog and website are provided for informational purposes only and is not intended to substitute obtaining accounting, tax, or financial advice from a professional accountant. Please consult a professional regarding your specific situations. Contact our team for more information.