How Are Trading Losses Treated for Tax Purposes?

When you sell a security, like a stock or bond, for less than you paid for it, the result is a capital loss. This event has tax implications, as the Internal Revenue Service (IRS) allows these losses to be used to reduce your overall tax liability. Understanding how these losses are treated for tax purposes is a component of managing your investments and your annual tax obligations.

Calculating Your Net Capital Loss

The first step is to calculate your net capital loss for the year. This process begins with the cost basis and the proceeds for each trade. The cost basis is the original price you paid for the security, including any commissions or fees, while the proceeds are the amount you received from the sale, minus any commissions or fees.

A distinction in this calculation is the holding period of the asset. Assets held for one year or less are classified as short-term, while those held for more than one year are long-term. This classification is important because short-term and long-term gains and losses are treated differently.

The calculation of your net capital loss involves a specific netting process. First, you net your short-term capital gains against your short-term capital losses to find your net short-term gain or loss. Separately, you net your long-term capital gains against your long-term capital losses to determine your net long-term gain or loss. These two resulting figures are then netted against each other to arrive at your final net capital gain or loss.

For example, a net short-term gain of $2,000 and a net long-term loss of $7,000 results in a total net capital loss of $5,000 for the year. This final figure determines your deductions and any potential carryovers.

Deducting Trading Losses

The primary use of a capital loss is to offset capital gains. If you have a net capital loss, it can be used to offset any capital gains you may have, reducing the amount of profit that is subject to tax. There is no limit to the amount of capital gains that can be offset by capital losses.

If your capital losses exceed your capital gains, you are left with a net capital loss for the year. The IRS allows you to deduct up to $3,000 of this net loss against other forms of income, such as your salary or interest income. This annual limit is $1,500 if you are married and filing separately. This deduction directly reduces your adjusted gross income (AGI), which can lower your overall tax bill.

Any net capital loss exceeding the $3,000 annual limit is not lost and can be carried forward to subsequent tax years indefinitely. This capital loss carryover can be used in future years to offset capital gains or to take the annual $3,000 deduction until the loss is used up.

When you carry over a loss, it retains its original character as either short-term or long-term. A carried-over long-term capital loss will first offset future long-term capital gains before being used against short-term gains.

The Wash Sale Rule Explained

The wash sale rule is a limitation on deducting trading losses. This rule prevents investors from claiming a tax loss on a security if they purchase a “substantially identical” security within 30 days before or 30 days after the sale. This 61-day window is designed to stop investors from selling a security simply to generate a tax loss while maintaining their position in that investment.

The term “substantially identical” is a key part of this rule. While the IRS has not provided a strict definition, it generally means shares of stock of the same company. Securities from different companies, even if they are in the same industry, are typically not considered substantially identical. The rule also applies to acquiring options to buy substantially identical securities within the 61-day period.

A loss disallowed by the wash sale rule is not permanently lost. The disallowed loss is added to the cost basis of the new, replacement shares. This adjustment defers the tax benefit until you sell the replacement shares, and the holding period of the new shares includes that of the original shares.

For instance, if you buy 100 shares for $1,000 and sell them for $750, you have a $250 loss. If you buy 100 shares of the same stock for $800 within 30 days, the wash sale rule applies. Your $250 loss is disallowed, and your cost basis in the new shares becomes $1,050 ($800 purchase price plus the $250 disallowed loss).

Trader Tax Status and Mark-to-Market Accounting

For highly active traders, the IRS makes a distinction between an “investor” and a “trader,” which can have significant tax consequences. Most people who buy and sell securities are considered investors, even if they trade frequently. To qualify for Trader Tax Status (TTS), an individual’s trading activity must be substantial, frequent, and continuous, with the goal of profiting from short-term price movements rather than long-term appreciation, dividends, or interest.

Qualifying for TTS allows a trader to treat their activity as a business and deduct related expenses, like software and data fees, on Schedule C. These deductions are not available to investors. However, gains and losses are still treated as capital gains and losses, subject to the wash sale rule and the $3,000 loss limitation.

A trader with TTS can make a mark-to-market (MTM) election under Section 475 of the tax code. This election changes how gains and losses are treated. Under MTM, all securities held at year-end are treated as if sold at their fair market value on the last business day of the year.

With the MTM election, gains and losses are treated as ordinary income or loss, not capital. This removes the $3,000 annual limit on deducting net losses, allowing traders to deduct their full trading losses in a given year. Additionally, the wash sale rule does not apply. This election must be made by the original due date of the prior year’s tax return, which is April 15 for individuals.

Reporting Losses on Tax Forms

You must report your trading activity to the IRS on specific tax forms. The two main forms are Form 8949, Sales and Other Dispositions of Capital Assets, and Schedule D, Capital Gains and Losses. These forms work together to calculate your final net gain or loss.

On Form 8949, you list the details of each transaction, including the asset description, acquisition and sale dates, proceeds, and cost basis. The form is divided into sections for short-term and long-term transactions. You must also indicate if the basis was reported to the IRS by your broker.

After completing Form 8949, you transfer the totals from each section to the corresponding lines on Schedule D. Schedule D summarizes this information to calculate your total net short-term and long-term capital gains or losses. The final result from Schedule D is then carried over to Form 1040.

If you have a wash sale, you report the transaction on Form 8949, enter code “W” in column (f), and adjust the loss amount. A capital loss carryover from a previous year is reported on a designated line on Schedule D to be included in the current year’s calculations.