Can Long-Term Capital Losses Offset Ordinary Income?

When an investment is sold for less than its purchase price, it results in a capital loss. If that investment was held for more than one year, it is classified as a long-term capital loss. The Internal Revenue Service (IRS) has specific rules that dictate how these losses must be used. These rules require losses to first offset capital gains before they can be deducted against other forms of income.

The Capital Loss Netting Process

Before a loss can reduce your regular income, it must go through a netting process detailed on Schedule D of your tax return. This requires you to consolidate all your capital transactions for the year. The first step is to net your long-term capital gains and losses against each other. For instance, if you realized a $10,000 long-term gain and a $4,000 long-term loss, your net long-term capital gain would be $6,000.

You must perform the same calculation for your short-term transactions, which are investments held for one year or less. If you had a short-term gain of $2,000 and a short-term loss of $7,000, this would result in a net short-term capital loss of $5,000. Short-term gains are taxed at your ordinary income tax rates, which are higher than the rates for long-term gains.

The final step is to combine the net long-term and net short-term figures. If one is a gain and the other is a loss, you subtract the smaller number from the larger one. Using the examples above, your $6,000 net long-term gain is netted against your $5,000 net short-term loss. This leaves a final net long-term capital gain of $1,000. If the final result is a net loss, it can be considered for deduction against other income.

Deducting Net Capital Losses from Ordinary Income

If the netting process results in a total net capital loss, the IRS allows you to deduct a portion of that loss against your ordinary income. This includes income from wages, salaries, and interest. This deduction reduces your adjusted gross income (AGI), which can lower your overall tax bill for the year.

There is an annual limit on how much net capital loss can be deducted from ordinary income. The amount is capped at $3,000 per year, or $1,500 if you are married and file a separate tax return. For example, if you have a total net capital loss of $8,000, you can only use $3,000 of it to reduce your ordinary income in the current tax year.

This deduction is claimed on your Form 1040, supported by the calculations on Schedule D. If you have a net capital loss, you must apply it against your income up to the annual limit.

Handling Losses Exceeding the Annual Limit

When your net capital loss exceeds the $3,000 annual deduction limit, the excess amount is not lost. The IRS permits you to carry it forward to subsequent tax years. This capital loss carryover can be used to offset future capital gains or be deducted against ordinary income up to the annual limit in those years.

The character of the loss, whether long-term or short-term, is preserved when carried forward, which affects how it is treated in the future netting process. For example, if you have a $10,000 net long-term capital loss in one year, you would deduct $3,000 from ordinary income. The remaining $7,000 is carried to the next year as a long-term capital loss to be used in that year’s netting.

Losses can be carried forward indefinitely until they are completely used up. Each year, you file a Schedule D to report the carryover amount and apply it against new capital gains or the ordinary income deduction.

Important Limitations and Definitions

The “wash sale” rule prevents you from claiming a capital loss on a security if you purchase the same or a “substantially identical” one within 30 days before or after the sale. This 61-day window stops investors from selling a security for a tax loss only to immediately buy it back. If a sale is a wash sale, the loss is disallowed and is instead added to the cost basis of the new security.

The rules for deducting capital losses apply to capital assets, which for most individuals includes investments like stocks, bonds, and mutual funds. Real estate can also be a capital asset, but not all property qualifies for this treatment.

Personal-use assets, such as a primary residence or a car, are also capital assets. However, while you must report gains from selling personal-use assets, losses on these sales are generally not deductible. For example, if you sell your personal vehicle for less than you paid, you cannot use that loss to offset capital gains or ordinary income.