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Capital losses can help cut your tax bill

Tax Guide » Tax Credits » 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 bank stock 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 only losses 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.)

But when you do have a true loss in a tax year (that means you took the loss by Dec. 31), you might be able to turn it into a tax advantage when you file that year's tax return. 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.

And investment losers could actually turn out to be surprise winners for parents who find that they are going to owe more, thanks to the earnings of assets held by their children.

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How it works

It's touching that the Internal Revenue Service 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 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 how it works:
  • Short-term losses counterbalance those expensive short-term gains. What's left at the end of Section I of Schedule D 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 Section II of Schedule D, 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. 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 the total is a gain, you'll be paying taxes on that.
  • 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.

 

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