Capital Loss Carryover: When the Market Gives You Lemons...

by Michael on Jan 23, 2014

Graph of Stock Market Crash

A few years ago, when the stock market was down in the dumps and investors were taking a beating, tax loss harvesting was all the rage.

In short, people were locking in paper losses with the intention of using them to offset their gains. And, in many cases, people (like me!) wound up with a ton of losses.

So what’s an investor to do when they have an excess of losses? Well, a portion can be used to offset ordinary income and the rest can be carried forward to future years. Today I’m going to talk a bit about how that works…

Using losses in the current year

For starters, you need to match up losses with equivalent gains. So short-term losses are used to offset short-term gains (otherwise taxed as ordinary income) and long-term losses are used to offset long-term gains (otherwise taxed at a favorable rate).

Note: Short-term losses/gain apply to assets held less than a year. Conversely, long-term losses/gains apply to assets held more than a year.

If, at that point, you still have losses remaining, you combine the two types and use them to offset remaining gains. And if you still have losses remaining…

You can use those losses to offset up to $3k in ordinary income. This is a rather nice, albeit somewhat limited, benefit since ordinary income is taxed at a higher rate than long-term capital gains.

As an aside, it might sound like the short-to-short and long-to-long matchup doesn’t matter since you subsequently pool remaining losses and can apply one type to the other. But there are cases in which this does matter.

Consider, for example, a year in which you have $5k in short-term gains and $5k in long-term gains. In that case, a $5k short-term loss leaves you with $5k in long-term gains whereas a $5k long-term loss leaves you with $5k in short-term gains.

Carrying losses forward to future years

Anyway, after all of that, if you still have losses remaining, you can (as noted above) carry them forward for use in the future. And if your remaining losses still exceed your gains in the next year, you can once again offset $3k in ordinary income and continue carrying the balance forward.

This is actually the situation that we’re in. We harvested a boatload of losses and haven’t realized any gains since. Thus, we’ve been offsetting $3k in ordinary income in each of the past few years and will continue to do so for the foreseeable future.

But beware the wasted loss…

Finally, a word of warning… If you’re in the lowest (10% or 15%) tax brackets, your long-term gains are taxed at 0% but you’re still expected to use your accrued losses to offset those gains. Thus, you’re essentially wasting your harvested losses.

In other words, think carefully before intentionally realizing losses.

If, for whatever reason, you find yourself with losses while in a low tax bracket, you may be able to partially remedy the situation by doing some tax gain harvesting. That is, realizing some (otherwise taxable) gains while stepping up the cost basis in a portion of your taxable holdings.

Just be careful. As a general rule, it’s probably best to run the numbers and estimate the impact of your actions before making a tax move that you might regret.


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