How to Help Your Clients Offset Capital Lossesby
Many of my clients are active stock traders. Some have reaped enormous profits on their investments.
Others are maladroit stock pickers and have suffered enormous losses. When they grumble about how severely the IRS restricts deductions for these, I remind them there are perfectly legal opportunities to circumvent the restrictions.
The big hurdle is a deduction cap of $3,000 for both married couples and single filers. The cap drops to $1,500 for married persons who file separately from their spouses.
This is the amount of capital losses investors can use to reduce their ordinary income—a wide-ranging category that includes income received from sources like salaries, pensions, interest and distributions from IRAs, 401(k)s and other tax-deferred retirement plans. These dollar limits haven’t increased since they went on the books in 1978, when Jimmy Carter was in the White House.
In my experience, many individuals focus only on the $3,000 ceiling. They are completely unaware the tax code allows people to use their investment losses to offset capital gains on other kinds of assets.
For instance, the law allows taxpayers to offset losses realized on stock and bond sales in their taxable account against gains on sales of capital assets other than stocks and bonds. This opportunity opens up many possibilities: They might offset their stock market losses against gains stemming from sales of collectibles, personal residences and vacation homes.
Here’s a real-life example: A client I’ll call Lydia met with me to discuss the pending sale of her personal residence. She expects her profit to considerably exceed the applicable exclusion amount for sellers (up to $500,000 for married couples filing jointly and up to $250,000 for single individuals and married couples filing separate returns).
My no-brainer advice: She should realize existing paper losses on some of her stocks and offset those against the taxable part of the gain from her home sale.
How much is Lydia allowed to deduct, and when? It depends. The law lets her use capital losses to erase taxes on capital gains realized during the same tax year, up to the total amount of the latter. The IRS couldn’t care less whether she mixes short- and long-term gains and losses.
Suppose Lydia actively trades stocks and makes many bad bets, resulting in a situation where her net capital losses greatly exceed her gains.
The good news: She won’t have to pay taxes on any of her realized capital gains. But how much additional tax relief can she count on for 2018? The answer: Not all that much. She gets to offset the net losses against no more than $3,000 of her ordinary income.
How quickly will Lydia be able to apply her unused losses, above that $3,000, to 2019 and succeeding years? Consider an example: For 2018, active trader Lydia has losses of $260,000 and gains of $240,000, with $40,000 from selling some winning stocks and $200,000 from the gain on the sale of her home, over and above the exclusion amount. Thanks to her losses, Lydia saves $6,000 in taxes on her winning stocks and $30,000 on her home sale, assuming she would have paid capital gains taxes at 15 percent.
After offsetting those gains, Lydia is left with a net loss of $20,000 in 2018. On Form 1040’s Schedule D, she subtracts $3,000 of the loss from her ordinary income and is allowed to carry forward $17,000 from 2018 into 2019. On 2019’s Schedule D, she uses the remaining loss (unless it’s offset by realized capital gains that same year) to trim her ordinary income by no more than $3,000 and then carries $14,000 forward from 2019 to 2020, and so on indefinitely.
Additional articles. A reminder for accountants who would welcome advice on how to alert clients to tactics that trim taxes for this year and even give a head start for next year: Delve into the archive of my articles (more than 250 and counting).