Capital Loss Limitation and Carryover

The capital loss limitation is one of the most important facts of life in the tax world of an investor. It creates an asymmetry of critical importance: large capital gains are fully taxable, but large capital losses are only partly deductible.

Use first against capital gain

Your tax rate on ordinary income from sources such as wages and interest income is taxed at a higher ratIf you have capital loss in the same year you have capital gain, you have to apply the capital loss against that gain before you can apply it against ordinary income. You may be in a

Capital loss limitation

Your capital loss for any tax year applies first against capital gain. Any additional loss can be deducted against ordinary income up to a limit of $3,000 per year.

Example: You have $10,000 of capital gain and $12,000 of capital loss. The capital loss reduces your capital gain to $0, and you claim the remaining $2,000 of capital loss as a deduction against your ordinary income.

Example: You have $5,000 of capital gain and $12,000 of capital loss. You’ll use $5,000 of the capital loss to reduce your capital gain to $0. You have another $7,000 of capital loss, but you can deduct only $3,000 against ordinary income. The remaining $4,000 produces no tax benefit this year, but carries over to the next year.

The capital loss limitation is one of the few federal income tax figures that are not adjusted for inflation. It has been $3,000 nearly half a century, since 1978. If inflation adjustments applied, it would be over $12,500 by now.

Character of loss

If your overall capital loss includes both short-term and long-term loss, the part deducted against ordinary income comes first from the short-term loss.

Example: You have $2,500 of short-term loss and $2,500 of long-term loss, with no capital gain. Your overall capital loss is $5,000, and you deduct $3,000 of that amount against ordinary income.  This deduction comes first from your short-term loss, so you’re left with $2,000 of unused long-term loss.

This rule is unfavorable in that you would rather preserve short-term loss for later use, because it counts first against short-term gain that would be taxed at higher rates. Yet the rule makes sense because you’re using this portion of your loss against ordinary income.

Capital loss carryover

Loss that remains unused because of this limitation can be carried over to the next year, retaining its character as short-term or long-term loss. The carryover loss is added to any other capital loss you may have that year and allowed subject to the same limitation. Any loss that remains unused in the carryover year will again carry over to the next year.

Example: In year 1 you have $22,000 of capital loss and no capital gain. You deduct $3,000 and a capital loss of $19,000 is carried over to year 2. In year 2 you have (in addition to this carryover) capital gain of $8,000 and capital loss of $2,000. Your carryover is added to the capital loss, for a total of $21,000. Of this amount, $8,000 is applied to the year 2 capital gain, another $3,000 is allowed against ordinary income, and the remaining $10,000 carries over to year 3.

Forward, not back

There are times when it would be helpful to carry a capital loss back to a previous year, getting a refund for tax previously paid on capital gain. Unfortunately, this is not permitted. Capital losses carry forward, not back. This restriction can create a painful situation known as a capital loss whipsaw.

Time limit

There is no limit to the number of years you can carry a capital loss forward. However, you can’t pass it on to your estate or heirs. Your capital loss expires when you do.