As long as you have to pay taxes on your stock market investment profits, it is important to know how to take advantage of stock investing losses to lower your overall income tax bill. Of course, in a perfect world, you would never have any stock market losses to deduct. All your investments would be hugely profitable, and you would never be down even $1. Unfortunately, it does not usually work out that way for anyone, not even Warren Buffett. However, one comforting note you can remember whenever you do experience a loss is that losses can be applied to reduce your tax bill. To get the maximum tax benefit, you must strategically deduct losses in the most tax-efficient way possible.
Stock market losses are capital losses or may be referred to by the somewhat confusing phrase, capital gains losses. Conversely, stock market profits are capital gains. According to U.S. tax law, the only capital gains or losses that can impact your income tax bill are "realized" capital gains or losses. In reference to deducting stock market losses, a stock investment loss only becomes a realized capital loss when you sell it. If you continue to hold onto the losing stock into the new tax year, that is, after Dec. 31, then it cannot be used to create a tax deduction.
Although the sale of any asset you own can create a capital gain or loss, for tax purposes, realized capital losses are used to reduce your tax bill if the asset sold was owned for investment purposes. Fortunately, stocks fall within this definition. It is noteworthy, however, that a taxable capital gain can be created by the sale of any asset, not just those used for investment purposes. For example, if you sell a coin collection at a loss from what you paid for it, that does not create a deductible capital loss. However, if you sell the collection for a profit, the profit is taxable income.
Determining Capital Losses
To calculate for income tax purposes, the amount of your capital loss for any stock investment is equal to the number of shares sold, times the per share adjusted cost basis, minus the total sale price. The cost basis price, which refers to the fact it provides the basis from which any subsequent gains or losses are figured, of your stock shares is the total of the purchase price plus any fees, such as brokerage commissions or fees.
The cost basis price has to be adjusted if during the time you owned the stock there was a stock split. In that case, you need to adjust the cost basis in accord with the magnitude of the split. For example, a 2-to-1 stock split necessitates reducing the cost basis for each share by 50%.
Deducting Capital Losses
To deduct your stock market losses, you have to fill out Form 8949 and Schedule D. Stock investing capital losses are classified as short-term capital losses or long-term capital losses in the same way as capital gains profits. Short-term capital losses are calculated against short-term capital gains, if any, on Part I of Form 8949 to arrive at the net short-term capital gain or loss. If you did not have any short-term capital gains for the year, then the net is a negative number equal to the total of your short-term capital losses.
On Part II of Form 8949, your net long-term capital gain or loss is calculated by subtracting any long-term capital losses from any long-term capital gains. The next step is to calculate the total net capital gain or loss from the result of combining the short-term capital gain or loss and the long-term capital gain or loss. That figure is entered on the Schedule D tax form. For example, if you have a net short-term capital loss of $2,000 and a net long-term capital gain of $3,000, then you are only liable for paying taxes on the overall net $1,000 capital gain.
If the total net figure between short- and long-term capital gains and losses is a negative number, representing an overall total capital loss, then that loss can be deducted from other reported taxable income, up to the maximum amount allowed by the Internal Revenue Service (IRS). As of 2015, the maximum amount that can be deducted from your total income is $3,000 for someone whose tax filing status is married, filing jointly. For someone who is single, or married but filing separately, the maximum deduction is $1,500. If your net capital gains loss is more than the maximum amount, you may carry it forward to the next tax year. The amount of loss that was not deducted in the previous year, over the limit, can be applied against the following year's capital gains and taxable income. The remainder of a very large loss, for example $20,000, could be carried forward to subsequent tax years and applied up to the maximum deductible amount each year until the total loss is figured into your income tax calculations.
A Special Case: Bankrupt Companies
If you own stock that has become worthless because the company went bankrupt and was liquidated, then you can take a total capital loss on the stock. However, the IRS wants to know on what basis the value of the stock was determined as zero or worthless. Therefore, you should keep some kind of documentation of the zero value of the stock, as well as documentation of when it became worthless. Basically, any documentation that shows the impossibility of the stock offering any positive return is sufficient. Acceptable documentation shows nonexistence of the company, canceled stock certificates or evidence the stock is no longer traded anywhere. Some companies that go bankrupt allow you to sell them back their stock for a penny. This proves you have no further equity interest in the company and documents what is essentially a total loss.
Considerations in Taking Stock Losses for Tax Deductions
Always attempt to take your tax-deductible stock losses in the most tax-efficient way possible to get the maximum tax benefit. To do so, think about the tax implications of various losses you might be able to deduct.
Since long-term capital losses are figured at the same lower tax rate as long-term capital gains, you get a larger net deduction for taking short-term capital losses. Therefore, if you have two stock investments showing roughly equal losses, one you have owned for several years and one you have owned for less than a year, then while you may choose to take both losses, if you only want to realize one of the losses, selling the stock you have owned for less than a year is more advantageous since the capital loss is figured at the higher short-term capital gains tax rate.
It is generally better to take any capital losses in the year for which you are tax-liable for short-term gains, or a year in which you have zero capital gains, because that results in savings on your total ordinary income tax rate. Do not try selling a stock right at the end of the year to get a tax deduction, and then buy it right back in the new year. If you sell a stock and then repurchase it within 60 days, the IRS considers this a "wash sale," and the sale is not recognized for tax purposes.
Your income tax bracket matters. If you are in the 10 or 15% tax bracket, you are not liable for any taxes on capital gains. Therefore, you do not have to worry about offsetting any such gains by taking capital losses. Regardless of tax implications, the bottom line on whether you should sell a losing stock investment and thus realize the loss should be determined by whether, after careful analysis, you expect the stock to return to profitability. If you still believe the stock will ultimately return a substantial profit for you, then it is probably unwise to sell it just to get a tax deduction. However, if you determine your original assessment of the stock was simply mistaken, and do not expect it to ever become a profitable investment, then there is no reason to continue holding onto the investment when you could go ahead and take the loss and use it to obtain a tax deduction.
