The Internal Revenue Service, or IRS, usually taketh, but sometimes it giveth, too. And that’s the case with any stock losses you have. The taxman allows you to write off investment losses – called capital losses – on your income taxes, reducing your taxable income and netting you a small tax break in the process.
Here’s how to deduct stock losses from your taxes and claim your tax break.
Writing off your loss: How it works
The IRS allows you to deduct from your taxable income a capital loss, for example, from a stock or other investment that has lost money. Here are the ground rules:
- An investment loss has to be realized. In other words, you need to have sold your stock to claim a deduction. You can’t simply write off losses because the stock is worth less than when you bought it.
- You can deduct your loss against capital gains. Any taxable capital gain – an investment gain – made that tax year can be offset with a capital loss. If you have more losses than gains, you have a net loss.
- Your net losses offset ordinary income. No capital gains? Your claimed capital losses will come off your taxable income, reducing your tax bill.
- Your maximum net capital loss in any tax year is $3,000. The IRS limits your net loss to $3,000 (for individuals and married filing jointly) or $1,500 (for married filing separately).
- Any unused capital losses are rolled over to future years. If you exceed the $3,000 threshold for a given year, don’t worry. You can claim the loss in future years or use it to offset future gains, and the losses do not expire.
- You can reduce any amount of taxable capital gains as long as you have gross losses to offset them. For example, if you have a $20,000 loss and a $16,000 gain, you can claim the maximum deduction of $3,000 on this year’s taxes, and the remaining $1,000 loss in a future year. Again, for any year the maximum allowed net loss is $3,000.
- The last day to realize a loss for the current calendar year is the final trading day of the year. That day might be December 31, but it may be earlier, depending on the calendar.
You can enter any stock losses and gains on Schedule D of your annual tax return, and the worksheet will help you figure out your net gain or loss.
It’s also important to know that short-term losses offset short-term gains first, while long-term losses offset long-term gains first. However, once losses in one category exceed the same type, you can then use them to offset gains in the other category. Short-term gains and losses are for assets held less than one year, while long-term gains and losses are for assets held longer than a year.
Because short-term gains and long-term gains may be taxed at different rates, you’ll need to keep your gains and losses straight as you strategically plan your taxes.
In general, long-term capital gains are treated more favorably than short-term gains. So you may consider taking a loss sooner than you might otherwise, in order to minimize your taxes. Or you might try to use low-tax long-term gains to offset more highly taxed short-term gains.
In fact, many investors strategically plan when and how they’re going to realize their losses, and make sure to minimize their taxable income each year, typically by selling their losing investments near the end of the tax year. It’s a process called tax-loss harvesting, and it can save you real money.
How much can you save?
So how much does claiming a stock loss save you on your taxes? The answer to that question depends on your tax bracket and whether your loss is offsetting a taxable gain or ordinary income:
- If you’re offsetting a taxable gain with a loss, then you’re saving the tax on the gains that you would otherwise have paid, and that figure can vary based on whether the gain was long-term or short-term.
- If you’re claiming a net loss, however, it’s easier to show how much you can save. Federal tax brackets run from 10 percent to 37 percent. So a $3,000 loss on stocks could save you as much as $1,110 at the high end (37 percent * $3,000) or as little as $300, if you’re in the lowest tier.
And if you pay state taxes, then you may be able to save another 4 to 6 percent or more on top of these rates.
This kind of tax savings is why some people ensure that they’re claiming this loss every year.
Limits on the deduction – the wash sale rule
The IRS does limit your ability to claim a deduction on stock losses, so that you don’t game the system. The IRS will not let you immediately write off what’s called a wash sale. A wash sale occurs when you take a loss on an investment and then repurchase the investment within 30 days.
If you try to claim a wash sale as a deduction, the IRS will reject your deduction. You won’t ultimately lose the deduction, but you won’t be able to claim it until you stay out of the investment for at least that 30-day period following the loss. When you sell the repurchased stock later, even years later, you can claim the loss.
And don’t try any fancy footwork to try to dodge the rule. You can’t sell the stock and claim the loss, and then have your spouse repurchase the stock within the 30 days. If your partner is buying the stock in that 30-day window, you simply won’t be able to claim the loss.
Note that it’s perfectly fine to sell an investment within 30 days and claim a loss. The key element of the wash sale is to repurchase the stock within that window.
However, you may be able to wiggle through a loophole with some kinds of funds, for example, those based on popular indexes, such as the Standard & Poor’s 500. You can take a loss on one S&P 500 index fund but buy another one, and you’ll still be able to claim your loss and stay invested. This method works because these two different funds track the same index, so they have basically the same holdings, yet they are technically different funds.
Deducting a stock loss from your tax return can be a savvy move to reduce your taxable income, and some investors take great pains to ensure that they’re getting the most out of this rule each year. However, you might want to be careful that you’re not selling a stock just to get the tax break, if you think it’s a good long-term investment. Selling an otherwise good stock at a low point may mean you’re selling just as it’s about to rebound.