Do Short-Term Gains Offset Long-Term Losses?

When you sell an investment, such as stocks or bonds, the outcome is either a capital gain or a capital loss. This is determined by the difference between your purchase price, or basis, and the sale price. A capital asset includes most property you own for personal use or as an investment, and the tax treatment of gains and losses depends on how long you held the asset.

Assets held for one year or less are classified as short-term, and a profit from their sale is a short-term capital gain. Assets held for more than one year are considered long-term, and a profit from selling them results in a long-term capital gain. This distinction is meaningful because different tax rates apply to each category, influencing your overall tax liability.

The Capital Gain and Loss Netting Rules

The Internal Revenue Service (IRS) requires a multi-step process, known as netting, to determine your final taxable capital gain or deductible loss. The first step involves netting transactions within their own category. All short-term gains and losses are combined to find a net short-term result, and the same procedure is performed for all long-term transactions to find a net long-term result.

Once you have the net results for both categories, the next step is to net these two results against each other. If you have a net short-term gain and a net long-term loss, you must use the long-term loss to reduce your short-term gain. For example, a $10,000 net short-term gain would be offset by a $4,000 net long-term loss, leaving a $6,000 net short-term capital gain to be taxed.

This final netting step can provide a tax benefit. Short-term capital gains are taxed at your ordinary income tax rates, which are often higher than the rates applied to long-term capital gains. By offsetting these higher-taxed gains with long-term losses, you reduce the amount of income subject to your highest marginal tax rate. The rules also work in reverse, as a net short-term loss would be used to offset a net long-term gain.

Treatment of Net Capital Losses

If the netting process results in a net capital loss for the year, the tax code allows you to deduct a portion of this loss against other forms of income, such as wages. Taxpayers can deduct up to $3,000 of a net capital loss against their ordinary income annually. For individuals who are married but file separate tax returns, this annual limit is reduced to $1,500.

This deduction lowers your adjusted gross income (AGI). For instance, if you have a total net capital loss of $2,000 for the year, you can deduct the full $2,000 against your ordinary income. If your net capital loss is $5,000, your deduction for the current year is capped at $3,000.

Capital Loss Carryovers

If your net capital loss for the year exceeds the annual deduction limit, the excess amount is not lost. The tax law allows you to carry the remaining loss forward to subsequent tax years. This carried-forward loss, known as a capital loss carryover, can be used in following years to offset capital gains.

Should your losses still exceed your gains in a future year, you can again deduct up to the annual limit against your ordinary income. This process can be repeated indefinitely until the entire carryover loss has been used. An important aspect of the carryover rule is that the loss retains its original character as either short-term or long-term. A long-term capital loss that is carried over will first offset future long-term gains before it can offset short-term gains.

Reporting on Tax Forms

Reporting capital gains and losses to the IRS involves specific forms that organize your transaction data. The primary forms for this purpose are Form 8949, Sales and Other Dispositions of Capital Assets, and Schedule D, Capital Gains and Losses. You begin by listing the details of each asset sale on Form 8949, which is divided into parts for short-term and long-term transactions.

For each sale, you must report a description of the property, the date acquired, the date sold, the sales price, and the cost basis. Your broker provides this information on Form 1099-B, which you use to complete Form 8949. After detailing all transactions, you transfer the summary totals to Schedule D. Schedule D is where the official netting calculation takes place to determine your final net capital gain or loss, which is then reported on your main tax return, Form 1040.

The Wash Sale Rule

Investors managing their capital gains and losses must be aware of the wash sale rule. This rule prevents taxpayers from claiming a capital loss on the sale of a security if they acquire a “substantially identical” security within a 61-day period: 30 days before the sale, the day of the sale, and 30 days after the sale. The purpose of this rule is to stop investors from creating an artificial loss for tax purposes while maintaining their investment position.

The definition of “substantially identical” can include not just the same stock but also options to buy that stock. If a loss is disallowed due to the wash sale rule, it is not permanently lost. Instead, the disallowed loss amount is added to the cost basis of the new, replacement security you purchased. This adjustment postpones the tax benefit of the loss until you sell the new security. For example, if you have a $1,000 disallowed loss and the new shares cost $5,000, your new basis becomes $6,000.