Investing and taxes go hand in hand. When you sell a stock at a profit through a taxable brokerage account, you owe taxes on the realized gain.
But the Internal Revenue Service (IRS) also offers tax benefits, including the ability for investors to deduct stock losses. These losses, called capital losses, serve to reduce your taxable income and reduce your tax bill.
Here’s how to deduct inventory losses from your taxes and what to look out for.
Writing off your losing stock trades: how it works
The IRS allows you to deduct a capital loss from your taxable income, for example from a stock or other investment that has lost money. Here are the basic rules:
- An investment loss must be realized. In other words: you must have sold your shares to be able to claim a deduction. You can’t simply write off losses because the shares are worth less than when you bought them.
- You can deduct your loss from the capital gain. Any taxable capital gain – an investment gain – realized in that tax year can be offset against a capital loss from that year or against a capital loss carried forward from a previous year. If your losses exceed your profits, you have a net loss.
- Your net losses offset ordinary income. No capital gains? Your claimed capital losses are deducted from 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 couples who submit a joint application) 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 profits, 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 loss of €20,000 and a gain of €16,000, you can claim the maximum deduction of €3,000 on this year’s taxes, and the remaining loss of €1,000 in a subsequent year. Again, for each year, the maximum allowable net loss is $3,000.
- The last day on which you can realize a loss for the current calendar year is the last trading day of the year. That day could be December 31, but it could also be earlier depending on the calendar.
You can enter any stock gains and losses on Schedule D of your annual tax return, and the worksheet will help you calculate your net gain or loss. If your situation is complicated, it is best to consult a tax advisor.
It is also important to know that short-term losses first offset short-term gains, while long-term losses first offset long-term gains. However, once the losses in one category exceed the same type, you can use it to offset the gains in the other category. Short-term gains and losses refer to assets held for less than one year, while long-term gains and losses refer to assets held for more than one year.
Because short-term gains and long-term gains can be taxed at different rates, you need to keep your gains and losses on the same page as you strategically plan your taxes.
In general, long-term capital gains are treated more favorably than short-term gains. So you may want to consider taking a loss earlier than you otherwise would to minimize your taxes. Or you can try using the low-tax long-term gains to offset the more heavily taxed short-term gains.
In fact, many investors strategically plan when and how they are going to realize their losses to ensure that they minimize their taxable income each year, usually by realizing investment losses near the end of the tax year. It’s a process called “tax loss harvesting” and it can really save you money. However, tax loss harvesting is not limited to the end of the year, and can be a useful practice throughout the year.
Deducting a loss is only valuable in a taxable account, and not in tax-advantaged retirement accounts, such as IRAs and 401(k)s, where capital gains are not taxed.
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How to determine your capital losses
Capital gains and losses are divided between long-term and short-term gains and losses. When you have both long-term and short-term gains and losses in a given tax year, there are ordering rules to use when matching capital gains and capital losses.
- Long-term capital gains and losses occur after the security has been held for at least one year. Meanwhile, there is a short-term gain or loss for securities sold or disposed of after being held for less than a year.
- Long-term capital gains and losses must be offset against each other, as do short-term gains and losses. For example, you may have realized $500 in gains on one long-term position while losing $200 on another, which would result in a net long-term gain of $300 for the year. Use the same process to calculate your short-term net profit.
- Then the long-term net profit or loss must be offset against the short-term net profit or loss.
- What remains after this settlement process will be taxed accordingly if the net result is a long-term or short-term capital gain, or deductible as described above in the case of a net capital loss.
- If possible, your tax loss harvesting efforts should try to avoid a net short-term capital gain, since these gains are taxed at your ordinary income tax rate rather than the typically preferable long-term capital gains rates. This will help minimize taxes on your investments each year.
Bankrupt companies are an exception that you should take into account
If you own shares where the company has declared bankruptcy and the shares have become worthless, you can generally deduct the full amount of your loss on those shares – up to the annual IRS limits with the ability to carry forward excess losses to future years .
The IRS expects you to have sufficient documentation of your cost basis in inventory to demonstrate the amount you lost in this situation. It is not necessary to actually sell the shares to claim a capital loss.
How much can you save by claiming inventory loss?
How much does claiming inventory loss save you on your taxes? The answer to that question depends on your tax bracket and whether your loss offsets a taxable gain or ordinary income:
- Offsetting a taxable gain against a loss saves you the tax on the gain you would otherwise have paid, and that figure can vary depending on whether the gain was long-term or short-term.
- However, if you claim a net loss, it is easier to demonstrate how much you can save. Federal tax brackets range 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 at the low end.
And if you pay state taxes, you may be able to save another 4 to 6 percent or more on top of these rates.
These types of tax savings are why some people make sure they claim this loss every year.
Limitations on the deduction – the wash sale rule
The IRS limits your ability to claim a deduction on stock losses so you don’t game the system. The IRS won’t let you write off what’s called a wash sale. A wash sale occurs when you take a loss on an investment and buy a ‘substantially identical’ investment within 30 days before or after.
If you try to claim a wash sale as a deduction, the IRS will disclaim 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 the 30-day period after the loss. When you sell the purchased shares later, even years later, you can claim the loss.
And don’t try any fancy footwork to avoid the rule. You can’t sell the shares and claim the loss, then have your spouse buy back the shares within 30 days. If your spouse purchases the stock within that 30 day period, you simply cannot claim the loss.
Selling an investment in a taxable account and then repurchasing the same investment in a retirement account such as an IRA within the wash-sale period will also wipe out your ability to claim the loss.
Some traders may try to buy the stock before trying to claim the loss, but that won’t work either. For example, a trader may have 100 shares of a losing stock that he wants to get rid of for tax write-offs. The trader then buys 100 shares of the same stock and sells 100 shares a week later. That would still be a wash sale since it occurred within the 30 day period before the sale.
Keep in mind that it’s okay to sell an investment within 30 days and claim a loss. The key element of the wash sale is to buy back the inventory within that 30 day period.
In short
Deducting a stock loss from your tax return can be a smart move to lower your taxable income, and some investors go to great lengths to ensure they make the most of this rule every year. However, you might want to be careful not to sell shares just to get a tax break if you think it’s a good long-term investment. Selling an otherwise good stock at a low point could mean you’re selling just as it’s about to recover.
Editorial Disclaimer: All investors are advised to conduct their own independent research into investment strategies before making any investment decision. In addition, investors are advised that the past performance of investment products does not guarantee future price increases.
