Capital losses can help cut your tax bill
Plummeting stock prices can cast a dark cloud over anyone's finances. However, at tax time, these capital losses can produce a ray of write-off sunshine.
When you sell any pharmaceutical flops or banking blunders, you can use them to offset gains from more successful ventures -- or even a portion of your everyday income.
A capital loss is the result of selling an investment at less than the purchase price or adjusted basis. Any expenses from the sale are deducted from the proceeds and added to the loss.
The key point is that capital losses are losses only after you sell them. A stock sitting in your portfolio with a deflated price may cause you distress, but it doesn't do you any tax good until you dump it. (The sale of personal-use property, such as a car, doesn't get this favored tax treatment. Such losses can't be deducted as capital losses.)
You can recoup a percentage of a true loss from the taxman. This is one of the best deductions available to investors. A capital loss directly reduces your taxable income, which means you pay less tax. It makes for a nice consolation prize.
How it works
It's touching that the IRS wants to give you a break when the stock market tanks. However, this doesn't mean the weighing and applying of capital losses is simple.
You must fill out Form 8949 and Schedule D, where you'll discover that losses are categorized as short-term and long-term, just like gains. The value of the deductible loss depends on how the loss is applied. Sadly, the taxpayer doesn't get to choose.
Here's what to do:
- Short-term losses counterbalance those expensive short-term gains. What's left at the end of Part I of Form 8949 is the net short-term capital gain or loss. If there were no gains, then obviously the net would equal the total loss.
- Long-term losses are applied to long-term gains. The result, at the end of Part II of Form 8949, is the net long-term capital gain or loss. Again, if you only have a loss, then the net is a negative number.
- Next, you combine the short-term and long-term results on Schedule D. At this point, a loss in one section can offset a gain in the other section. For example, if you have a net short-term loss of $1,000 and a net long-term gain of $1,200, then you'll pay tax on only $200.
- If there's still a loss, you can deduct up to $3,000 from other income.
- If you had a really bad year and ended up with a net loss of more than $3,000, you can carry forward the leftover portion to next year's taxes. The unused loss can be applied to next year's gains as well as up to $3,000 of earned income. A big loss can be used as a deduction indefinitely -- another important reason to keep good records.
'Kiddie tax' complications
Child's investment income limits
In an effort to catch rich parents who were trying to circumvent investment taxes by putting assets in the names of their children, the "kiddie tax" was enacted in 1986. Don't be confused by the name. Under this law, a kiddie portion of taxes usually is quite large.
Basically, the law requires a child's investment earnings over a certain amount to be taxed at the parent's higher tax rate until the child reaches a specific age: 19, or 24 if the child is a full-time student.
If parents find themselves liable for more investment income than they had planned because they had to cover the taxes on their children's asset earnings, one of the easiest ways for that parent to reduce or eliminate the unexpected gains is to sell assets that produce offsetting losses.