The Internal Revenue Service provides a tax benefit for losses incurred on investments. The IRS calls this tax benefit a deduction, not a tax credit. Although you must follow the government's rules for claiming investment losses, a qualifying capital loss can reduce your taxable capital gains. Depending upon the circumstances, an investment loss can even offset a portion of your earned income.
Deduction and Credit
An investment loss gives you a deduction, which is different from a tax credit. According to the IRS definitions, a credit directly comes out of the taxes you owe, while a deduction reduces the income subject to taxes. If you owe $12,000 in income taxes and receive a $5,000 tax credit, you reduce your taxes due by $5,000, to $7,000. However, if your income equals $50,000, a deduction of $5,000 reduces your taxable income by $5,000, to $45,000. The actual tax savings in this case depends upon your tax bracket. A capital loss provides the second type of reduction because it reduces your taxable income.
Personal and Investment Property
The IRS requires taxpayers to report capital gains on every type of property as income, even gains on the sale of personal property, such as a home. However, you cannot deduct losses on property you owned only for your own use, such as your home, car or boat. You can only deduct losses on property you owned as an investment, such as stocks, bonds or rental property.
When you sell a capital asset for less than your cost basis, you have a capital loss. The loss is short-term if you owned the property a year or less and long term if you had it for more than a year. This matters because normally the tax rate on long-term capital gains is lower than for other income. Use Schedule D to report losses and gains from the sale of assets. Schedule D requires you to total short-term losses and gains separately from long-term losses and gains. Your investment losses will reduce your taxable capital gains, if you have any.
Deduction for Excess Losses
In any tax year when your capital losses are larger than your gains, you have a net loss. You can deduct a maximum $3,000 on your annual tax return, or up to $1,500 if you pay taxes as married filing separately. Transfer your net loss from Schedule D to Form 1040, line 13. This excess loss then reduces other forms of taxable income, such as salaries or wages.
If you have offset your capital gains and reduced this year's income by the maximum amount for your filing status, carry over any remaining investment loss to the the following year. Enter the carry-over on Schedule D for the new tax year as a deduction against capital gains. If the carry-over loss is more than the new year's capital gains, use up to $3,000 on Form 1040 as a deduction from the second year's other income. The limit is $1,500 if married filing separately. In other words, use the excess in the same way as in the initial filing period. (See Reference 1.)
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