Can I deduct capital losses from regular income?

Whether you can deduct capital losses from your regular income depends on the type of capital loss you incurred during the taxable year. The amount of the capital loss also varies based on the classification of the loss. A capital loss occurs when there is a sale of a capital asset. A capital asset is basically any property purchased by the taxpayer for investment or personal use. The purchase price of the capital asset is known as “basis.” When a capital asset is sold for less than its basis, a capital loss occurs and the taxpayer might be entitled to claim a deduction.

For example, if Mary purchases 5 shares of stock at $10.00 each for a total price of $50.00, but then later sells those 5 shares for $40.00, she incurs a capital loss of $10.00. Capital losses can only be deducted for losses incurred on investment property, not on personal property. Assume that you purchase an apartment complex with the sole intention of renting out the units. If you later sale that apartment complex at a loss, you will be entitled to a capital loss deduction. However, if you sell your primary residence for less than what you paid, you are not permitted to claim a capital loss deduction.

Types of Capital Losses

There are two types of capital losses, short-term and long-term. Short-term capital losses occur if you owned the property for less than a year and long-term capital losses occur when the property has been owned for more than one year. The distinction between short-term and long-term capital losses is important because if a taxpayer wants to reduce tax liability, only short-term capital losses can be used to offset short-term gain and long-term capital losses can only be used to offset long-term capital gains. However, both types of capital losses can be deducted from regular income.

Limits on Capital Losses that May be Deducted

There are also limits on the amount of capital losses that taxpayers can deduct in one year. Taxpayers can only deduct up to $3,000 of capital losses each year. Those taxpayers who are married, but file separately can only deduct up to $1,500. However, taxpayers can only deduct capital losses from income if the total amount of capital losses exceeds the total amount of capital gains in one year. Assume that Mary incurred only a capital loss of $1,000 and did not experience any gain at all during the same year. Mary would be entitled to deduct the full $1,000 from income. But, what if Mary had incurred a capital loss of $5,000 and a capital gain of $1,000 in 2018? In that situation, Mary could only deduct $3,000 for the 2018 tax year. Why can Mary only deduct $3,000 when her total capital loss for 2018 was $4,000 ($5,000-$1,000)? Federal tax law only allows taxpayers to deduct up to $3,000 of capital losses each year and only if the loss exceeds the gain. But the total loss was $4,000 and Mary can only deduct $3,000 in 2018, what happens to the $1,000 difference? Federal tax law allows taxpayers to carry forward any capital losses that they were unable to deduct in the prior year. In 2019, Mary can use the leftover $1,000 from 2018 to offset any gains or to reduce her taxable income.

When filing individual tax returns, capital gains and losses should be reported on Schedule D and then transferred to line 13, Schedule 1, of Form 1040.

Case Studies: Deducting Capital Losses From Regular Income

Case Study 1: Short-Term Capital Loss

John purchased stocks in January and sold them at a loss in November of the same year. Since he held the stocks for less than a year, it is considered a short-term capital loss. As John prepares his tax return, he can deduct the amount of the loss from his regular income. This deduction helps offset his overall tax liability.

Case Study 2: Long-Term Capital Loss

Sarah invested in real estate and sold a property at a loss after owning it for three years. Since the property was held for more than a year, it qualifies as a long-term capital loss. Sarah can deduct the loss from her regular income when filing her taxes. This deduction helps reduce her taxable income and potentially lowers her overall tax liability.

Case Study 3: Limitations on Deductions

Mark had a turbulent year in the stock market, incurring several capital losses. He had a total of $8,000 in capital losses and no capital gains for the year. However, the tax law allows him to deduct a maximum of $3,000 in capital losses from his regular income. As a result, Mark can deduct $3,000 from his income for the current tax year. The remaining $5,000 in losses can be carried forward to future years and used to offset capital gains or reduce taxable income in those years.