Summary: Capital loss is the difference between a lower selling price and a higher purchase price, resulting in a financial loss for the seller. The IRS states that “If your capital losses exceed your capital gains, the excess can be deducted on your tax return”. Limits on such deductions apply. Special wash sale rules apply if the same or substantially similar security is bought, acquired, or optioned within 30 days before or after the sale.
Capital loss is when an investment is sold after it decreased in value from what it was purchased for. An easy way to think of what capital loss means is to take the purchase price and subtract the price it sold for and the result is the capital loss. For example, if an investment was purchased for $1,000 and then was sold for $600 the investment loss is $1,000 – $600, meaning a capital loss of $400.
Using Capital Losses to Offset Capital Gains
If an investor has multiple investments that are sold throughout the year, some will likely have gained value while others might have experienced losses. The money earned on the sales that improved are called capital gains. If the investor experienced capital loss then that amount is deducted from the capital gains.
If we use the $400 capital loss from the investment above, and if we had another investment that sold for $1,000 more than it was purchased for, then the capital losses deducted from the capital gains would show a net capital gain of $600. If those were the only two investment sales by the investor for the year then the $600 would be the reported capital gains for taxation.
The above example is simplified, as there are two types of investment periods that must be considered for taxation as well as the change in value amounts. Short-term investments are those that are bought and sold within one year. Long-term investments are held for more than one year. The tax rates for short-term investments are different from those that are long-term investments, so short-term losses must be subtracted from the short-term gains. Long-term losses must similarly be deducted from the long-term gains.
Capital Loss in Business v. Operating Loss
Businesses may also use investment strategies to buy stocks, bonds or other capital assets. Those business investments are also subject to capital loss.
Operating loss occurs when a business’s expenses are greater than their revenue. This distinction is important because, whether it’s for an individual or a business, a maximum of $3,000 in capital losses may be used per year as a deduction from income. Any losses greater than that can be carried forward to the next tax year, or beyond, until the losses have been fully deducted over time. Operating losses are deducted from income in full for that year, with no maximum, and no carry forward.
For example, if a business had $5,000 in capital loss, only $3,000 can be used as a deduction for that year’s income, and the remaining $2,000 can be used in the following year’s deductions. If the business had operating losses of $5,000 then all $5,000 is deducted in that immediate year, with none carrying forward.