How to Claim a Tax Deduction for Stock Losses

The coronavirus pandemic has caused dramatic declines in the stock market. Here is important information every investor should have on how you might be able to deduct stock market losses to offset some of the economic pain you are feeling in a market downturn.

Stocks Are Capital Assets

Investments you own such as stock, other securities, real estate, or a business are considered capital assets. Any time you sell a capital asset for less than you bought it for you incur a capital loss. You realize a capital gain whenever you sell a capital asset at a profit -- that is, you sell it for more than you paid for it. However, until you sell a capital asset, you have neither a gain nor a loss. The only time you actually get a deduction is when you sell your stock or other capital asset for a loss. Paper losses are not deductible.

How Much Is Your Loss?

To calculate your loss on a stock, you subtract the share's adjusted basis from the amount you sold it for. The adjusted basis is the share's original purchase price plus brokerage fees and any other fees incurred. If your stock split since you purchased it, you must reduce its adjusted basis to reflect the fact that you own additional shares. For example, if you got two shares for one, you reduce your basis by 50%.

Short-Term vs. Long-Term Capital Losses

There are two types of capital losses: short-term and long-term. A capital loss is short-term if you owned the stock for less than one year. The loss is a long-term capital loss if you owned the stock for more than one year. You need to calculate your short-term and long-term capital losses separately.

To figure out your short-term capital gain or loss for the year, you add up all the losses from all the shares that you owned for less than one year and you add up all the gains from all the shares that you owned for less than one year. You then subtract your overall losses from your overall gains. If you had no gains (only losses), you don't need to do any subtraction. The total overall gain or loss is your short-term capital gain or loss for the year. To figure out your long-term capital gain or loss, you do the same thing with all the shares you owned for more than one year.

If you have gains or losses from selling other types of capital assets--rental property for example-- include them in these calculations.

You can deduct net losses of either type (short-term or long-term) from the other kind of gain. For example, you can deduct any net short-term capital loss from net long-term capital gains, and vice versa. The result is your total net capital loss or gain for the year.

$3,000 Limit on Capital Loss Deduction

You can deduct up to $3,000 of your total net capital losses against any other income you earned. This other earned income can be from any source, such as a job or interest or dividend income. If you're unfortunate enough to lose more than $3,000 during the year, you can carry forward your unused losses indefinitely to future years. Each year, you get to first apply the carried forward losses against capital gains, and then use any remainder (up to $3,000) to reduce your ordinary income.

Example: Dave purchased 100 shares of XYZ Corp. six months ago and sold them for a $12,000 loss. This is a short-term capital loss. He also sold his shares in the ABC Mutual Fund that he purchased 20 years ago. Although the ABC fund has declined in value this year, Dave still earned a $7,000 profit on the sale--a long-term capital gain. Dave subtracts his $12,000 short-term loss from his $7,000 long-term gain, resulting in a $5,000 net capital loss. Dave may deduct $3,000 (the limit) of the loss from his salary income for the year. Dave is in the 24% income tax bracket, so this saves him $720 in federal income taxes. He carries forward the other $2,000 in losses to deduct in future years.

To claim this deduction, complete IRS Form 8949, Sales and Other Dispositions of Capital Assets and Schedule D, Capital Gains and Losses and include these with your tax return.

Tax Loss Harvesting

Deducting capital losses is called tax loss harvesting and is a commonly used as year-end tax planning strategy. Sometimes when investors harvest their losses at the end of the year they buy back the same stock or other securities. This way they benefit from their capital loss but can continue to own the security.

If you do this, however, you must be careful not to run afoul of the wash-sale rule. Under this rule, if you buy back the same stock or other security within 30 days after the sale, you cannot claim the losses on your tax return for the year. The wash sale rule also applies if you buy shares within 30 days before you sell them.

Tax loss harvesting is purely a strategy to save on taxes without regard to the underlying value of the investment. Even if a stock you've purchased has gone down in value, harvesting your loss this year may not be your best long-term investment decision. Also, remember that capital gains or losses do not apply to tax-deferred accounts, such as your 401(k) or IRA, so tax loss harvesting is not possible for investments held in these accounts.