One of the most disappointing things about a down market is the fact that your investments are likely losing value. You can lessen the pain of investment losses by
deducting them on your taxes (up to a certain point, unfortunately).
While this tax deduction isn’t the same as a dollar for dollar reduction in what you owe, it can reduce your income, and reduce your tax liability. However, you do need to make sure that you are taking your losses appropriately.
Filling Out Your Schedule D
In order to deduct investment losses, you need to first offset any investment gains you may have realized during the year. This means that you need to fill out a
Schedule D (this is the draft for 2012) with your Form 1040.
You start by filling in Section I, which deals with short-term gains and losses. You first use your short-term losses to offset short-term gains. Then, you move on to
Section II, where you use long-term losses to offset long-term gains. Any difference is balanced out at the end of the form.
So, if Section I shows that you had a net short-term loss of $800, and Section II shows a net long-term gain of $700, you can apply the net loss from Section I to the
net gain in Section II, and it will offset those gains – plus leave a total net less from your investments at $100.
Applying Your Losses to Other Income
You have to first apply your investment losses against your investment gains. However, if there is still a net loss, you can then apply that amount – up to $3,000 –
to offset other income. In our example, you would receive a $100 deduction for the net losses.
But what if you end up with a net investment loss of more than $3,000? The good news is that you can actually carry the leftover portion over to another year. So,
if you had a total loss of $5,000 on your investments (after offsetting your capital gains), you can deduct $3,000 from your earned income this year, and then carry
forward the other $2,000 to the next tax year.
It’s worth noting that tax losses can be carried forward in this way indefinitely. If you keep good records of your investment losses and your deductions, it’s possible
to keep moving forward. So, if you saw a big loss, of maybe $10,000 this year, you could keep carrying forward your losses, in increments of $3,000 a year, until the
loss had been completely deducted over time.
Watch Out for the Wash Rule
Make sure, though, that you don’t run afoul of the wash sale rule. If you want to deduct your investment losses from your income, you can’t turn around and buy the same thing you sold at a loss. The rule is in place because it’s tempting to sell at a loss, and then buy the same stock again while it is discounted. You get the tax deduction, and you stand to make a tidy profit because of your new purchase.
The IRS doesn’t allow this if you want to take a deduction. You have to wait at least 30 days to make a purchase of a “substantially identical” investment at a lower
price. It’s not illegal to perform this maneuver, but it will prevent you from taking the capital loss deduction.