If you are an investor, you know that you may need to pay capital gains taxes when you sell an investment at a profit. At the same time, however, and especially in an unpredictable market, stock losses can loom large for your investment portfolio. When you sell an investment for less than you paid, you take a capital loss. Are stock losses tax deductible?

If you are an investor, you know that you may need to pay capital gains taxes when you sell an investment at a profit. At the same time, however, and especially in an unpredictable market, stock losses can loom large for your investment portfolio. When you sell an investment for less than you paid, you take a capital loss. Are stock losses tax deductible?

In short, yes. Capital losses can be deducted on your tax return, whether to reduce your ordinary income up to a specific limit or to reduce or eliminate your liability for capital gains taxes. Here is some additional information to help you understand how to handle stock losses when filing your tax return.

Stock Losses are Capital Losses Which Means…

Essentially, you have a capital loss whenever you sell an investment and receive less than you originally received. You do not experience a capital loss just because the price of one of your investments takes a dip — in short, the losses must be realized in order to be deducted. That means, you must have sold the investment; if you continue to hold the stock despite the price dip, it has no effect on your annual taxes. In addition, if you sell the investment after the end of the tax year (after Dec. 31 of the year in question), those losses do not apply to the taxes from the prior year.

Capital losses are not restricted to traditional stocks. They also apply to other kinds of investments in your portfolio including bonds, mutual funds, futures, derivatives and other securities, real estate investments and cryptocurrency. However, tax deductions do not apply to items for your personal use, like the home in which you live or your car, if you sell it after owning it for some time. Instead, you must have held the item as an investment. (There are some types of assets that could be considered investments that are also ineligible, such as collectibles; a CPA can provide more specific advice about your non-traditional investments.)

How Much Capital Loss can be Deducted?

Like capital gains, capital losses can be divided into short-term and long-term losses. When you held the stock or securities or less than a year, you have short-term losses, while long-term losses apply if you have held the investment for a year or more. As with gains made, losses are handled differently depending on how long you had the investment.

In any given tax year, the maximum net capital loss you can deduct is $3,000, if you are filing individually or married filing jointly. If you are married filing separately, the maximum capital loss you can deduct in one year is $1,500. If you lost more than that amount in one year, this does not mean that the deduction is lost entirely, however. You can roll over losses that exceed $3,000 to future years or use it to offset gains in future years. The losses do not expire, so you can claim them continually until the entire amount has been offset.

It is important to note that this maximum applies to net losses — that is, after your losses have already been subtracted from your capital gains. This means, if you lost $15,000 and gained $10,000 during the year, you have a capital net loss of $5,000. You can deduct $3,000 this year and roll over the remaining $2,000.

Short term capital gains and losses offset each other, while long term capital gains and losses are offset against each other. After this process, long-term and short-term gains and losses are netted against one another. Taxes are then applied to an overall net gain or deducted in case of an overall net loss. Be aware that short-term capital gains are taxed less favorably than long-term capital gains, at your ordinary income tax rate. Therefore, you should generally seek to minimize your net short term capital gains for each tax year.

Filing a 8949 Form

In order to deduct your capital losses for the tax year, you will need to file Form 8949 with your tax return as well as Schedule D. On Part I of Form 8949, you calculate your short term capital gains and losses against one another to arrive at your net short-term proceeds.

Part II of the the 8949 form calculates your long term capital gains and losses against one another to determine the net result. The next step is to calculate the total net capital loss or gain from both of the above sections. The final net figure is then entered into Schedule D.

You are responsible only for paying taxes on a net capital gain reported after calculating Form 8949. If you have a net loss, you can then deduct up to $3,000 from other reported taxable income.

It is important to keep records of all of your sales, including those that resulted in both gains and losses, in case of a potential audit. This is also important if you plan to roll over capital losses from stock sales at a loss for deduction on future years’ tax returns.

Wash sale rule complications

Tax loss harvesting is a strategy that you can use to sell your stocks and other securities in a timely fashion in order to claim the maximum deduction on your tax return and offset your capital gains. It is used most frequently to offset short term capital gains because they are taxed at a higher rate than long-term gains. In general, long-term gains have a more favorable tax rate than your ordinary income. In most cases, investors may use tax-loss harvesting at the end of the year to offset greater short term capital gains.

However, you will also want to maintain your portfolio. In most cases, an investor will choose to replace the asset they sold with a similar stock with a related profile in order to maintain their ideal asset mix, risk level and level of returns. This can be a useful investment and taxation strategy.

At the same time, it is important to steer clear of the “wash sale rule.” The wash sale rule prohibits taking a deduction when you sell an investment at a loss and then repurchase the same or a “substantially identical” investment within 30 days of the reported sale. You do not lose the deduction for the loss, but it cannot be claimed until you finally sell off the same or the “substantially identical” security, even if the sale takes place years later. Similarly, you cannot repurchase the stock in your IRA, and your spouse repurchasing the stock will also run afoul of the wash sale rule. Re-purchasing the stock indirectly through a derivatives contract or call option also invalidates the loss for that tax year.

For the average investor, this should not pose a problem; you simply have to avoid re-buying the same stock within 30 days after selling it for a loss. There are options that investors can use to help maintain their portfolio balance; for example, exchange-traded funds or ETFs often track a specific index or balance of assets, such as the S&P 500. If you sell your investment in one ETF tracking an index and then purchase another, this generally does not violate the wash sale rule and can be a safe way to maintain your portfolio balance while seeking a favorable tax outcome.

What about bankrupt companies?

When a company has declared bankruptcy and the stock no longer has value, you can generally deduct the entire amount of your loss on that stock. You do not need to actually sell the shares, as they typically become unsellable or are no longer listed on their previous exchange.

However, it is important to document when the stock became worthless, records that the company declared bankruptcy and proof that the stock reached a zero or near-zero value. In essence, you want to have documentation that shows that it is impossible for the stock to produce a positive return, including proof of liquidation or evidence that the stock has been de-listed. Some bankruptcy processes may offer a de minimis stock buyback for an amount like one penny, which can also provide valuable documentation for the claim this year and in future years for rollover losses.

How much can you save by claiming a stock loss?

The specific amount you can save depends on your income tax rate, whether your losses are offsetting long term capital gains, short term capital gains or ordinary income, and other factors.

If you are offsetting your taxable gains with losses, you are saving the amount of taxes you would have paid on the gains. In general, this is a higher level of savings when you are offsetting short term capital gains.

If you have a net loss, you are deducting it against your ordinary income. At the highest tax bracket, you could save as much as $1,110 on your taxes each year ($3,000 at a 37% tax rate, down to a much lower amount at a lower income tax rate. You may also be able to deduct stock losses against your state taxes, depending on your local rules.

Your Bottom Line

In short, deducting your stock losses can provide significant savings on your taxes. Managing your investments to reduce your tax burden, particularly applied to short term capital gains or ordinary income, can be a valuable strategy for tax savings. Of course, as you take more complex deductions and report the results of more investments, your taxes can quickly grow more complex. In order to avoid mistakes and protect yourself in case of a potential IRS audit, consult with a professional CPA to make sure you are maximizing your savings and avoiding any problematic IRS rules.