How to Offset Long-Term Capital Gains

When an investment is sold for a profit, the resulting gain is a taxable event. A long-term capital gain, which occurs when an asset is held for more than one year before being sold, is subject to this tax. The tax rates on these gains are more favorable than those applied to ordinary income. For 2025, these rates are 0%, 15%, or 20%, depending on the taxpayer’s filing status and total taxable income. Investors can use several legitimate methods to reduce the amount they owe on these profits.

The Capital Loss Offsetting Rules

The Internal Revenue Service (IRS) provides a specific process for offsetting capital gains with capital losses. A short-term capital loss results from selling an asset held for one year or less, while a long-term capital loss comes from an asset held for more than one year. The rules require a hierarchical netting of these gains and losses.

The first step is to net gains and losses within the same category. Long-term capital losses must first be used to offset long-term capital gains. Similarly, short-term capital losses are first applied against short-term capital gains.

After this initial step, if a net loss remains in one category, it can be used to offset a net gain in the other. For instance, if an investor has a net long-term gain of $8,000 and a net short-term loss of $5,000, the short-term loss can be used to reduce the long-term gain. This leaves a final net long-term capital gain of $3,000 that is subject to tax.

Implementing Tax-Loss Harvesting

A strategy for managing capital gains tax is tax-loss harvesting, which involves intentionally selling investments at a loss to offset realized gains. The effectiveness of this strategy is governed by the wash-sale rule. This rule is designed to prevent investors from claiming a tax loss on a security while maintaining their investment position.

The wash-sale rule disallows a loss deduction if an investor purchases a “substantially identical” security within 30 days before or after the sale that generated the loss, creating a 61-day window. If the rule is violated, the loss is not deductible in the current year. Instead, the disallowed loss is added to the cost basis of the newly acquired security, which can reduce the taxable gain on a future sale of that new position.

The IRS has not provided a rigid definition of “substantially identical,” leaving it to a case-by-case determination. Selling shares of a specific company’s stock and repurchasing shares of the same stock within the 61-day window is a violation. Conversely, selling an exchange-traded fund (ETF) that tracks the S&P 500 index from one provider and buying an S&P 500 ETF from another is not considered a wash sale, as differences in management and expense ratios make them distinct.

The IRS applies the wash-sale rule across all accounts owned or controlled by the taxpayer and their spouse, including tax-deferred accounts like IRAs. An investor cannot sell a security at a loss in their taxable brokerage account and then repurchase a substantially identical one in their IRA within the prohibited window without triggering the rule. Careful tracking across all investment accounts is necessary to ensure compliance.

Utilizing Capital Loss Carryovers

When an investor’s total capital losses for a tax year exceed their total capital gains, the excess net capital loss can be used to reduce other forms of income. The IRS allows a taxpayer to deduct up to $3,000 of this excess loss against their ordinary income, such as wages and interest. For those who are married and file separately, this annual deduction limit is $1,500.

Any net capital loss that remains after taking the $3,000 deduction is not forfeited. This remaining amount is carried forward to subsequent tax years as a capital loss carryover. It can be used to offset future capital gains or be deducted against ordinary income up to the annual limit, and there is no limit to the number of years an unused loss can be carried forward.

The character of the loss is preserved during the carryover process. A long-term capital loss that is carried forward will first be used to offset future long-term capital gains before it can be applied to short-term gains. Likewise, a short-term loss carryover will first offset future short-term gains.

Advanced Offsetting Strategies

One advanced method involves donating appreciated securities directly to a qualified charitable organization. To qualify for the tax benefits, the donated asset, such as stocks or mutual funds, must have been held for more than one year. This approach allows the donor to avoid paying the capital gains tax that would have been due if they had sold the asset first and then donated the cash proceeds.

In addition to avoiding the capital gains tax, the donor may be eligible to claim a charitable contribution deduction for the full fair market value of the securities. This deduction for appreciated non-cash assets is limited to 30% of the donor’s adjusted gross income (AGI). A five-year carryover period applies for any excess contributions.

Another strategy is investing in a Qualified Opportunity Fund (QOF), an investment vehicle created to spur economic development in designated communities. By rolling over a capital gain into a QOF within 180 days of the sale, a taxpayer can defer the tax on that gain until as late as December 31, 2026, or until the QOF investment is sold, whichever comes first. If the QOF investment is held for at least 10 years, any appreciation on the QOF investment itself may be free from capital gains tax.

Reporting on Your Tax Return

The initial step in reporting involves detailing each sale of a capital asset on Form 8949, Sales and Other Dispositions of Capital Assets. For each transaction, you must report details such as the description of the asset, the date it was acquired, the date it was sold, the sales price, and the cost basis.

Form 8949 is structured to separate short-term transactions from long-term transactions. This separation is necessary because the totals from Form 8949 are then carried over to Schedule D. Schedule D summarizes all capital gain and loss activity for the year.

On Schedule D, the final netting of gains and losses occurs. This results in the ultimate net capital gain or loss figure that is then reported on the taxpayer’s main Form 1040.