How Tax Loss Harvesting Carry Forward Works
Understand how net capital losses exceeding the annual deduction limit are carried forward to reduce your taxable income in subsequent years.
Tax loss harvesting is an investment strategy that involves selling assets at a loss to offset capital gains taxes. When total losses from these sales exceed total gains in a given year, the excess loss is not forfeited. The capital loss carry forward mechanism allows taxpayers to use these excess losses to reduce their tax liability in future tax years.
Calculating Your Net Capital Loss
To determine if you have a loss to carry forward, you must first calculate your net capital loss for the current tax year. This process separates transactions based on how long you held the asset. Assets held for one year or less generate short-term gains and losses, while assets held for more than one year result in long-term gains and losses. This distinction is important because short-term and long-term gains are taxed at different rates.
You begin by netting all your short-term transactions, subtracting total short-term capital losses from total short-term capital gains. This results in either a net short-term gain or loss. You then perform the same calculation for your long-term transactions to find your net long-term figure.
The final step is to net the short-term and long-term results against each other. For instance, if you have a net short-term loss of $2,000 and a net long-term gain of $5,000, you would arrive at a final net long-term capital gain of $3,000. Conversely, a net short-term gain of $4,000 and a net long-term loss of $10,000 results in a net long-term capital loss of $6,000.
Applying the Annual Deduction Limit
Once you have calculated a net capital loss for the year, you can use it to lower your taxable income. A net capital loss is first used to offset any capital gains you may have, reducing them to zero. If a loss remains, the Internal Revenue Service (IRS) has specific rules about how much can be applied against other forms of income.
After offsetting capital gains, taxpayers can deduct up to $3,000 of the remaining net capital loss against their ordinary income. This includes income from wages, salaries, or self-employment. For those who are married and file separate tax returns, this annual limit is reduced to $1,500. This deduction directly reduces your adjusted gross income (AGI).
This $3,000 figure is an annual ceiling for deducting capital losses against ordinary income. For example, if you have a total net capital loss of $12,000 for the year and no capital gains, you would apply $3,000 of that loss to reduce your ordinary income. The remaining $9,000 is addressed by the carry forward mechanism.
The Carry Forward Mechanism
Any net capital loss that remains after taking the annual $3,000 deduction is not lost. This excess amount is carried forward to subsequent tax years. There is no time limit for this rule; the losses can be carried forward indefinitely until they are completely used up, allowing taxpayers to eventually receive the full benefit.
When losses are carried forward, they maintain their original character as either short-term or long-term. For example, if your $9,000 carry forward loss was composed of $2,000 in short-term losses and $7,000 in long-term losses, they retain that classification. In the following year, these carried-over losses are combined with any new gains and losses, following the same netting rules. Short-term carryover losses will first be netted against new short-term gains, and long-term carryover losses against new long-term gains.
Consider a taxpayer with a $9,000 long-term capital loss carry forward. In the next year, they realize a $5,000 long-term capital gain. The $9,000 carry forward loss would first offset this $5,000 gain completely, leaving a remaining loss of $4,000. If the taxpayer has no other gains, they can then deduct $3,000 of this remaining loss against their ordinary income, leaving $1,000 to be carried forward. The Capital Loss Carryover Worksheet in the instructions for Schedule D can be used to track these amounts.
Reporting and Key Considerations
The details of each individual asset sale, such as the purchase date, sale date, and cost basis, are reported on Form 8949, Sales and Other Dispositions of Capital Assets. The totals from Form 8949 are then summarized on Schedule D, Capital Gains and Losses. This form is filed with your Form 1040 tax return and is where the netting calculations are formally documented.
An important regulation to be aware of when engaging in tax loss harvesting is the Wash Sale Rule. This rule prevents a taxpayer from claiming a loss on the sale of a security if they purchase a “substantially identical” security within 30 days before or after the sale. This 61-day window is designed to stop investors from generating a tax loss only to immediately buy it back.
If a transaction is identified as a wash sale, the IRS disallows the capital loss deduction for that year. Instead, the disallowed loss is added to the cost basis of the newly purchased replacement security. This adjustment postpones the tax benefit of the loss until the replacement security is sold in the future.