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In the investing world, you hear about capital gains a lot more than you hear about capital losses. People prefer to talk about their investing successes rather than their blunders, and the fact that capital gains are taxed also makes them a subject of interest. However, even the best investors experience capital losses now and then.
Fortunately, although capital losses lower our portfolio returns, they can also lower ourtaxes by offsetting gains and income. And thanks to the capital loss carryover, they can be applied to gains and income in future tax years.
First, let's quickly review what a capital loss is. A capital loss happens when you sell a capital asset (such as a stock, a bond, or real estate) for less than the price you bought it for. The selling part is important. If you own a stock that has lost 80% of its value, you're definitely looking at a sizable loss, but until you actually sell the stock, it's just a "paper" loss -- not a realized one. Meanwhile, if you sell a capital asset for a profit, you have a capital gain.
Long-term capital gains -- i.e., capital gains on assets that were held for longer than a year -- are taxed at rates ranging from 0% to 20%, but most of us (those in the 25%-35% income tax brackets) will pay a 15% tax on our long-term capital gains. Short-term capital gains -- i.e., gains realized on assets that were held for a year or less -- get taxed at ordinary income tax rates.
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Harvested losses can offset gains. Artist: Laurits Andersen Ring.
Offsetting gains and carrying losses forward
One handy use of capital losses is to offset gains, but there's a particular process for this. You first have to offset any long-term capital gains with long-term capital losses and any short-term capital gains with short-term capital losses. If your losses for one type exceed the gains for that type, they can then be applied to the other type.
It's also possible that your losses exceed all your gains. If so, you can then use up to $3,000 of those losses to reduce your taxable income (or $1,500 each for couples who are married and filing separately).
If you still have losses after all that, you get to take advantage of the capital loss carryover, which allows you to carry forward any remaining losses and apply them in subsequent years.
Knowing about capital loss carryovers can help you think strategically about taxes -- something you should more than once a year during tax season. As you rack up capital gains, think about whether you want to offset any of them with losses. This can help you recognize money-losing stocks that you may not want to own any longer, making them perfect tax-loss harvesting candidates.
If you're thinking about selling some stocks and generating losses, only to buy them back immediately, think again. If you buy an asset back within 30 days, the IRS considers the sale to have been a "wash sale," and you don't get to offset your gain with it. So make sure you wait 31 days or more to buy back any stocks you sold at a loss.
While being strategic about your investing and taxes is worthwhile, don't let tax concerns drive your investing decisions. For example, if you own stock in a company that you fully expect to do well over the long run, selling it just to harvest a loss is a bit risky, as it could rise in value before you got the chance to buy it back.
The more you know about capital loss carryovers and other investing and tax rules, the more you can save.
The article The Capital Loss Carryover Can Cut Your Taxes originally appeared on Fool.com.
Longtime Fool specialist Selena Maranjian, whom you can follow on Twitter,has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.
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