What Are the IRC 1211 Capital Loss Limitation Rules?
The tax code restricts how much capital loss can be deducted annually. Understand the rules governing the amount, timing, and application of these deductions.
When you sell a capital asset, such as stocks or real estate, for less than your purchase price, you realize a capital loss. The Internal Revenue Code (IRC) provides rules that govern how much of that loss you can use to lower your taxable income in a given year. These regulations, found in Section 1211, establish a limit on the amount of net capital loss that taxpayers can deduct annually. The rules differ significantly for individuals and corporations, reflecting their distinct financial structures.
Capital Loss Deduction Rules for Individuals
For individual taxpayers, the process of deducting capital losses begins with netting gains and losses. This involves categorizing all capital transactions for the year as either short-term (for assets held one year or less) or long-term (for assets held more than one year). Short-term losses are first subtracted from short-term gains, and long-term losses are subtracted from long-term gains.
Once the initial netting is complete, the net figures from both categories are combined. If you have a net loss in one category and a net gain in the other, the two are netted against each other. For instance, a net short-term gain can be offset by a net long-term loss.
If the final calculation results in a net capital loss, a deduction limit is imposed. You can deduct the full amount of your capital losses up to the full amount of your capital gains, plus an additional amount against other forms of income, like your salary. This additional deduction is limited to $3,000 per year for most taxpayers. For married individuals filing separate tax returns, this annual limit is reduced to $1,500 each.
Consider a taxpayer who has a net short-term capital gain of $2,000 and a net long-term capital loss of $12,000 for the year. First, the $12,000 long-term loss offsets the $2,000 short-term gain, leaving a net capital loss of $10,000. According to the rule, the taxpayer can then deduct $3,000 of that loss against their ordinary income.
Treatment of Unused Capital Losses
Capital losses that exceed the annual deduction limit are not lost. Instead, the tax code allows these excess losses to be carried forward to future tax years. The mechanism is known as a capital loss carryover.
When you carry over a loss, it retains its original character as either short-term or long-term. For example, if you have a $7,000 unused long-term capital loss, it will be treated as a long-term capital loss in the subsequent year.
In the next tax year, the carryover loss is combined with any new capital gains and losses from that year. The same netting rules apply: the carried-over loss will first offset gains of the same character. Any remaining loss is then used to offset gains of the other character, and finally, up to $3,000 can be deducted against ordinary income. This process repeats each year until the entire capital loss has been used.
Capital Loss Deduction Rules for Corporations
The regulations for corporate capital losses are different from those for individuals. Corporations can only use capital losses to offset capital gains. There is no provision for corporations to deduct any amount of net capital loss against their ordinary business income, such as revenue from sales or services.
If a corporation has a net capital loss for the year, it cannot use that loss to reduce its taxable business income. For example, if a corporation has $50,000 in capital gains and $70,000 in capital losses, it results in a net capital loss of $20,000. The corporation can use the losses to offset the gains, bringing the net capital gain to zero, but the remaining $20,000 loss cannot be deducted in the current year.
Instead of an immediate deduction against other income, corporations must carry the net capital loss to other tax years. The rules generally permit a corporation to carry a net capital loss back to the three preceding tax years and then forward for up to five years. The loss must be applied to the earliest year first. In those carryback or carryforward years, the loss can only be used to offset capital gains.