Capital Losses for Minors

One of the frequent questions on our message board is how to handle a capital loss in a custodial account under the Uniform Transfers to Minors Act (UTMA). In the typical situation, a parent or other relative set up the account and contributed money that was invested in stocks or mutual funds. Later they sell shares, either to change the investment or to make a withdrawal. Any loss on the sale is reported on the child’s income tax return. What if the child doesn’t have enough income to make use of the loss?

It’s the child’s loss

A capital loss from selling assets in a custodial account cannot be reported on the parents’ tax return. There’s a rule that allows parents to report the income of a child on their tax return in certain circumstances, but this option is available only when all the child’s income is from interest and dividends. If your child has capital gains or losses, all the child’s income (including interest and dividends) must be reported on a separate tax return for the child.

You can’t get around this rule by transferring the shares from the UTMA account to your own account before making a sale. Even if the transfer is allowed, you won’t be permitted to claim the loss when you sell the shares.

You just have to face up to the fact that any tax benefit from this loss belongs to the child. So what happens if the child doesn’t have enough income to use the loss?

Capital loss carryover

Many people are aware that a capital loss in excess of the $3,000 capital loss limitation can be carried over to the following year. They may not realize that it is also generally possible to carry over a loss that is unused because of insufficient income. For example, if your child has a $2,000 capital loss and only $500 of income from all sources, the loss will carry over to the next year. The amount that carries over will be the full $2,000, not just $1,500. That’s because the child’s standard deduction eliminates the $500 of income before you use any of the capital loss.

When you fill out the child’s tax return, it may look as if the capital loss, or part of it, is going to disappear without producing any tax benefit. That generally isn’t the case. To see this, you have to follow instructions precisely, both on the tax return and on the capital loss worksheet that’s used to figure the amount of capital loss that carries over. Let’s use our example of $2,000 of capital loss and $500 of income (we’ll assume it’s interest income). Here’s how the tax return should look:

• When you fill out Schedule D, Capital Gains and Losses, you have a loss of $2,000, and the instructions tell you to put that number on line 13 of Form 1040. It looks like the loss is being used up, but it isn’t.
• The loss will be combined with the $500 of interest income. Now it looks like $500 of the loss is being used up, but it still isn’t.
• Your child has adjusted gross income (the number at the bottom of page 1 of Form 1040) equal to ($1,500). (On your tax return, parentheses indicate a negative number, although you can use a minus sign instead.) It’s important to show this as a negative number, rather than filling in a zero.
• The child’s standard deduction is $1,050. (This is the amount for 2018.) When you subtract this from the adjusted gross income you get a bigger negative number: ($2,550).

This is significant: the negative number here is greater than the amount of the capital loss. That means there was no benefit from the capital loss, so the full amount should carry over.

Now you’re ready to calculate the capital loss carryover. This is done on a special worksheet the IRS provides in the instructions for Schedule D (for the previous year’s carryover) and in IRS Publication 550 (for the current year’s carryover). If you follow the instructions for this worksheet carefully, you should find that the entire $2,000 capital loss carries over to the following year — even though the loss appeared on line 13 of the tax return and was combined with the income of $500 as part of the tax calculation.

Using it

A capital loss carryover goes on Schedule D of the next year’s tax return, where it gets combined with any other capital gains and losses that may appear there. If the net result is another capital loss that is not fully used, then the loss can carry over to the next year and so on indefinitely. There is no time limit for using a capital loss carryover.

However, the capital loss must be used in the first year your child has enough income to use it. You aren’t allowed to skip a year when the loss would produce little or no benefit to preserve the loss for a year when the tax benefit would be greater. The amount that carries forward is the amount you couldn’t use, not the amount you chose not to use. As explained next, there are situations where the loss can disappear without producing any tax benefit at all.

Losing it

We’ve described a situation where the entire capital loss is preserved even though it appears on a tax return with other income. The loss can disappear without producing any tax benefit, however, if the child also has some capital gain income. The capital gain income could be from selling an investment, or it could be a capital gain distribution from a mutual fund. Either way, it will be combined with any capital losses from the same year, or carried over from a previous year, even if you don’t need the capital loss to eliminate tax on the capital gain.

Example: Suppose your child has a $2,000 capital loss carryover from the previous year, and this year has $500 of interest income and $250 of capital gain. Your child would pay zero tax even without the capital loss carryover, so you’d like to preserve the entire amount. You aren’t allowed to do that, though. You have to combine the capital loss carryover with the $250 capital gain. That leaves your child with a capital loss of $1,750, which carries over to the next year.

A capital loss can also be consumed without producing any tax benefit when claiming a personal exemption, but this isn’t an issue for dependent children (who can’t claim a personal exemption), and for the years 2018 through 2025 isn’t an issue for any taxpayers because the deduction for personal exemptions is eliminated for those years.