Calculating Capital Gains and Deducting Capital Losses

By | January 27, 2015

Planning for capital gains and deducting capital losses is a way to increase your long-term investment return. However, to calculate capital gains and understand capital losses correctly, taxpayers must understand several different tax laws. Taxes are often overlooked, but are a vital component of long term investment returns.


Offsetting Capital Gains with Capital Loss

The basic offsetting rule is pretty simple: Long-term capital losses offset long-term capital gains before they offset short-term capital gains. Similarly, short-term capital losses offset short-term capital gains before they offset long-term capital gains. One part of the rule is that you may use up to $3,000 of total capital losses in excess of total capital gains as a deduction against ordinary income in computing your adjusted gross income or AGI. This can be a great benefit for people in any income tax bracket. It will provide an immediate tax savings and realizing capital losses is quite easy.


Offsetting Capital Gains Rules

  • long-term gain with short-term gain
  • long-term loss with short-term gain
  • long-term gain with short-term loss
  • long-term loss with short-term loss

Individuals are subject to tax at a rate as high as 39.6% on short-term capital gains and ordinary income. The same rate as ordinary income will be used on short-term capital gains.


Long-term Capital Gains Rates

For most individuals long-term capital gains on most types of investment assets are taxed at a maximum rate of 15%. However, that 15% rate is

  • zero % to the extent the gain would otherwise be taxed at a rate below 25% if it were ordinary income and
  • 20% to the extent that the gain would be taxed at a 39.6% rate if it were ordinary income.

Taxpayers should try to avoid having long-term capital losses offset long-term capital gains since those losses will be more valuable if they are used to offset short-term capital gains or up to $3,000 per year of ordinary income. Make sure that the long-term capital losses are not taken in the same year as the long-term capital gains are taken.Remember to think about investment considerations before tax. It might not always make sense to do what is best tax wise that might lead to disastrous investment results.


Realizing Capital Losses (Tax Harvesting)

To the extent that taking long-term capital losses in a different year than long-term capital gains is consistent with good investment planning, you should take steps to prevent those losses from offsetting those gains. If you have yet to realize net capital losses for 2014, but expect to realize net capital losses in 2015 well in excess of the $3,000 ceiling, you should consider shifting some of the excess losses into 2014. That way the losses can offset 2014 gains and up to $3,000 of any excess loss will become deductible against ordinary income in 2014 The big hurdle is Internal Revenue Code Section 1211, which caps the deduction at $3,000 for both married couples and single filers. (Married couples who file separate returns are limited to a maximum deduction of $1,500 per person.)


Using Wash Sale Rule

Paper losses or gains on stocks may be worth recognizing this year in some situations. But suppose the stock is also an attractive investment worth holding for the long term. There is no way to precisely preserve a stock investment position while at the same time gaining the benefit of the tax loss, because the so-called “wash sale” rule precludes recognition of loss where substantially identical securities are bought and sold within a 61-day period (30 days before or 30 days after the date of sale). Thus, you can’t sell stock to establish a tax loss and simply buy it back the next day.

How to Avoid the Wash Sale Rule

However, you can substantially preserve an investment position while realizing a tax loss by using one of these techniques:

  1. Sell the original holding and then buy the same securities at least 31 days later. The risk is upward price movement.
  2. Buy more of the same stocks or bonds, then sell the original holding at least 31 days later. The risk here is downward price movement.
  3. Sell the original holding and buy similar securities in different companies in the same line of business. This approach trades on the prospects of the industry as a whole, rather than the particular stock held.

For mutual fund shares or ETFs, sell the original holding and buy shares in another mutual fund that uses a similar investment strategy.