spiral notebook and black pen

 

What Is It?

You are taxed on your earnings. Generally speaking, your earnings equal your income and gain, less your allowable expenses and losses. Because losses reduce your earnings, losses can help to reduce your tax liability. It is important, therefore, to know how losses arise, how losses are classified, and how losses are taxed. A thorough familiarity with the concept of losses may allow you to implement strategies to best utilize losses and to increase the after-tax return on your investments.

Caution: If you operate a business organized as a corporation, and the allowable deductions of that business exceed the business income, the business may have a net operating loss. This discussion is primarily about losses on your investments, and not on those of a corporation. Further, property held for personal use is a capital asset. Gain from the sale or exchange of that property is a capital gain. Loss from the sale or exchange of that property, however, is not deductible. You can deduct loss relating to personal use property only if it results from a casualty attributable to a federally declared disaster for 2018 to 2025.

Deductions, Losses, and Investments in General. What Deductions And Losses Are Generated By Your Investments?

Deductions and losses directly related to your investments are usually one of the following:

  • Transaction costs from the purchase or sale of an investment
  • Capital loss
  • Losses from pass-through businesses
  • Interest expense
  • Incidental investment expenses

How Do Deductions And Losses Impact Your Investment Earnings?

Deductions and losses reduce tax liability by lowering the amount of your income that is subject to tax. A variety of rules limit or disallow deductions for certain expenses or losses. To understand how deductions and losses impact your investment earnings, you need to know how to characterize deductions and losses, the limitations that apply to losses, and how to match losses with income or gain.

How Can Loss Strategies Increase Your After-Tax Return On Your Investments?

Loss strategies attempt to match up your gains and losses. For instance, when you have income or gain, you can generate and take advantage of losses. Similarly, when you have unused losses, you can generate income or gains.

Limitations on Investment Losses

Limitation on Investment Transaction Expenses

Investment transaction expenses, such as commission and charges associated with the purchase or sale of an investment, are generally not deductible. This amount must be added to basis. The effect of this rule is to decrease the gain or increase the loss on the sale of the investment.

Limitations on Capital Loss

Total capital losses for a tax year are generally deductible only to the extent of total capital gains for the same year. The capital gain loss rules are discussed below.

Limitations on Passive Losses

Losses from a passive activity are subject to special rules. A passive activity is generally a business activity in which you participate 500 hours or less a year. Rental activity is generally considered passive activity. Passive activity losses may only be used to reduce passive income. Thus, pass-through losses from a partnership or S corporation, which may be either ordinary or capital in nature, may be disallowed unless you have an equal amount of passive income from other sources.

Any disallowed losses from passive activities may be carried forward and used as a deduction against income from passive activities in future years. Unused passive activity loss carryforwards are allowed to be used in full when you dispose of your entire interest in the activity generating the passive losses in a fully taxable transaction.

Caution: Portfolio income is not passive income. Thus, your income and gain from your investments in stock and bonds cannot be used to offset passive losses.

Tip: If you actively participate in a passive rental real estate activity, you may be able to deduct up to $25,000 of loss from the activity from your income that is not passive income. You actively participate in a rental real estate activity if you (and your spouse) own at least 10 percent of the rental property and you make management decisions (e.g., approving tenants, deciding on rental terms, approving expenditures) in a significant and bona fide sense. The $25,000 amount is reduced if your modified adjusted gross income is more than $100,000, and special rules apply if you are married and file separate returns. See Internal Revenue Service Publication 925 for details.

Limitations on Incidental Investment Expenses

Prior to 2018, general investment expense such as subscriptions to investment periodicals, investment counseling charges or legal and accounting fees were deductible as itemized miscellaneous deductions to the extent they exceeded 2 percent of your adjusted gross income. Under the Tax Cuts and Jobs Act, previously deductible miscellaneous expenses subject to the 2% floor are no longer deductible for 2018 to 2025.

Limitations on Wash Sales

Losses are disallowed on wash sales. What is a wash sale? A wash sale occurs when you sell a security at a loss and then you reacquire the same or similar security shortly before or after the loss transaction.

Example(s): Assume you own 100 shares of X and 100 shares of Y. You sell X for a gain of $1,000. You sell Y for a loss of $1,000. You did this so you wouldn't have to pay tax on the gain. The next day you repurchased your Y shares. That's a wash sale. Your loss is disallowed. You have to pay tax on the gain from the X stock.

Tip: The loss isn't foregone; you add it back to the basis of the stock. So, when you sell the repurchased stock in the future, your basis is the cost of the stock plus the loss. In other words, your basis, subject to market fluctuations, equals the basis prior to the loss sale.

Capital Losses

In General

Generally, capital losses can only be used to reduce or offset capital gains. There is one exception, which we will discuss below. To understand the application of capital losses to reduce or offset capital gains and a limited amount of ordinary losses, you should be able to work through the following steps:

  • Net short-term capital gains and losses
  • Net long-term capital gains and losses
  • Apply net losses to gains

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Net Short-Term Capital Gains and Losses

Netting short-term capital gains and losses means determining a net gain or loss for your transactions involving investments held for one year or less. This produces a net short-term capital gain or loss. A net short-term gain is taxed at ordinary income rates. Short-term gains can only be reduced by short-term losses. Let's look at an example.

You sell the following stock this year:

Stock

Gain or Loss

Holding Period

W

Gain of $150

More than a year

X

Loss of $100

More than a year

Y

Loss of $150

Less than a year

Z

Gain of $100

Less than a year

Your short-term investments, Y and Z, produce a net loss of $50.

Net Long-Term Capital Gains and Losses

Netting long-term capital gains and losses means determining a net gain or loss for your transaction involving investments held for more than a year. This produces a net long-term capital gain or loss.

Assume you sell the following stock this year:

Stock

Gain or Loss

Holding Period

W

Gain of $150

More than a year

X

Loss of $100

More than a year

Y

Loss of $150

Less than a year

Z

Gain of $100

Less than a year

Your long-term investments, W and X, produce a net gain of $50.

Apply Net Losses to Gains

Now that you know your net gains and losses, let's see how losses are applied to gains. Here are the basic rules:

  • Net short-term capital gains are taxed at ordinary income tax rates
  • Net short-term losses reduce net long-term gain
  • Net losses (whether short- or long-term) may be used to offset up to $3,000 worth of ordinary income in a given year
  • Net losses exceeding $3,000 in a given year may be carried forward to reduce gains and income in future years

Caution: Note that married filing jointly taxpayers may offset up to $3,000 worth of ordinary income; married filing separately taxpayer are allowed to offset only $1,500 per year of ordinary income with capital losses.

The netting rules are fairly complicated.

Assume you sell the following stock this year:

Stock

Gain or Loss

Holding Period

W

Gain of $150

More than a year

X

Loss of $100

More than a year

Y

Loss of $150

Less than a year

Z

Gain of $100

Less than a year

Assume you have a net long-term gain of $50 and a net short-term loss of $50 (from the previous example). Since the short-term losses reduce the long-term gains, you have no gain this year.

Tip: Corporations carry capital losses back three years and forward five years.

Ordinary Losses

Ordinary losses reduce ordinary income. Aside from a few exceptions, your investments will usually not generate ordinary losses. Pass-through losses from S corporations and partnerships, however, will often be classified as ordinary. Keep in mind that substantial losses and deductions may subject you to the alternative minimum tax (AMT).

Caution: It is important that you do not confuse ordinary losses with net capital losses. Remember, net capital losses may offset only a limited amount of ordinary income each year. Excess capital losses may then be carried forward for use in subsequent years.

Loss Strategies

Understanding the rules relating to deductions and losses enables you to enhance the after-tax return on your investments by timing the recognition of losses so they match up against income or gains. Similarly, you can time the recognition of income or gains to utilize unused losses. Gains and losses on investments are not recognized until realized--you don't have gain or loss until you sell the investment. Thus, you control the recognition of, and thus the creation of, tax items such as gain or loss. You also control your deductions. You choose whether to make a deductible expense this year or the next.

Example(s): Assume that it is the end of the year. During the course of the year you sold some of your investments at a $100 gain. You currently own stock in X Corporation that is trading at a price less than what you paid for it. You have a paper loss. If you sell enough of X stock to produce a $100 loss, you will not have to pay tax on your $100 gain. You can then immediately reinvest these funds. Assuming that you do not run afoul of the wash sale rules, this reinvestment will not prevent your recognition of the loss. Effectively, you realized a paper loss without reducing your current wealth.

Tip: This strategy can be even more powerful if the deduction or loss generated removes you from a higher tax bracket.

 

 

This material was prepared by Broadridge Investor Communication Solutions, Inc., and does not necessarily represent the views of  The Retirement Group or FSC Financial Corp. This information should not be construed as investment advice. Neither the named Representatives nor Broker/Dealer gives tax or legal advice. All information is believed to be from reliable sources; however, we make no representation as to its completeness or accuracy. The publisher is not engaged in rendering legal, accounting or other professional services. If other expert assistance is needed, the reader is advised to engage the services of a competent professional. Please consult your Financial Advisor for further information or call 800-900-5867.

 

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The Retirement Group is a Registered Investment Advisor not affiliated with FSC Securities and may be reached at www.theretirementgroup.com.

 

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