How Do Investment Losses Affect Taxes?

By Maurie Backman Markets Fool.com

Nobody wants to lose money on an investment, but even in a strong market, it's possible to have a few individual stocks perform poorly. When this happens, you have a couple of choices. You can either hold onto your investments in the hopes they'll improve, or unload them before they drop in value even more.

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While opting for the latter might seem like an impulsive move, it can actually be quite strategic from a tax perspective. The reason? Current tax rules allow you to use stock losses to offset long-term and short-term capital gains. If you have other investments that you've sold at a profit, selling stocks at a loss for tax purposes could save you some money when you go to file your return.

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When investment losses aren't all bad

First, let's get one thing straight: In order to claim an investment loss on your taxes, it will need to be a realized loss. A realized loss occurs when you actually sell an investment at a price that's lower than what you initially paid for it.

If you bought 100 shares of a certain stock at $10 per share, and that stock is now trading at $5 per share, you're not down that $500 until you actually sell off that stock. Once you do, however, you can use that $500 loss to offset your capital gains. This means that if you sold a different investment for a $2,000 profit, you'd cancel out $500 of it by virtue of your loss.

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Of course, this isn't to say that you should automatically rush to take a loss any time one of your investments starts to decline. But if you have reason to believe that its value won't recover, and you have capital gains to pay taxes on, it pays to consider taking a loss.

But offsetting capital gains isn't the only tax break an investment loss can give you. If, after applying your losses to your capital gains, you're left with a net loss, you can use it to offset up to $3,000 in regular income.

Imagine you have a year with $2,000 in capital gains and $5,000 in capital losses. The first $2,000 will ensure you don't pay taxes on your gains. From there, you can apply the remaining $3,000 to your ordinary income and avoid paying taxes on that portion of it.

Furthermore, if your net loss for the year exceeds $3,000, you can carry the remainder to future tax years. The unused portion of your loss will first be applied to the following year's capital gains, followed by $3,000 of the following year's income.

But don't get cute

If you have an investment that's down toward the end of the tax year, you may be thinking of selling it in December, taking your loss, and buying it again at the start of the new year. But if you're not careful, you'll get caught in a wash sale. Selling a stock at a loss and then buying that same stock back within 30 days is considered a wash sale, and when that occurs, you lose the tax benefit of taking a loss. If you have poorly performing stocks you wish to sell for tax-loss purposes but then own again, you'll need to wait until the wash-sale period expires before repurchasing them.

Losing money on an investment is never ideal, but sometimes it pays to cut your losses and move on -- especially if you're convinced the investment in question won't rebound. Investment losses can not only lower your current tax burden, but carry forward to help offset future gains and income, as well. If you're smart about when and how you take those losses, they can actually work to your advantage.

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