by Julian Block
When securities markets swoon and apprehensive investors bail out of their holdings, they console themselves with deductions for capital losses when it comes time to file taxes.
But long-standing rules limit deductions for losses on sales or redemptions of shares of individual stocks, bonds, mutual fund shares and exchange-traded funds (ETFs) .
The big hurdle is Internal Revenue Code Section 1211, which caps the deduction at $3,000 for both married couples and single filers. (Married couples who file separate returns are limited to a maximum deduction of $1,500 per person.) These dollar limits haven’t been revised upward since they went on the books in 1978, when Jimmy Carter was in the White House.
In my experience, many individuals focus just on the $3,000 ceiling and forget that the tax code authorizes them to be resourceful when they incur capital losses. Section 1211 allows capital gains on investments to be fully offset by capital losses on other investments. There is also another significant break that investors fail to take advantage of: Losses on sales or redemptions of stocks, bonds, mutual funds or ETFs held in taxable accounts can be used to offset gains on sales of capital assets other than stocks, bonds, etc. This opens up many possibilities—for instance, profits on sales of collectibles, vacation homes, undeveloped land, active farms, commercial property of all kinds, and rental property.
Take, for example, the case of Marilyn Paul. Marilyn plans to sell her personal residence and anticipates a capital gain greater than the exclusion amount of up to $500,000 for married couples filing jointly or $250,000 for singles and married couples filing separate returns. Marilyn should consider realizing losses on, say, shares of stock or mutual funds to offset the taxable part of her gain.
Marilyn cannot use losses on assets held in traditional IRAs, 401(k)s, Keogh plans and other tax-deferred retirement accounts to offset her gains. Capital gains and losses in these retirement accounts are not taxed.
Income from qualified dividends cannot be offset by capital losses, either. Although qualified dividends are taxed at the same tax rate as long-term
capital gains in 2010, fine print buried in the tax code bars this offset. It matters not that the tax rate for qualified dividends is the same as that for capital gains.
Another constraint prohibits offsets of capital losses against income from conversions of money moved out of traditional IRAs into Roth IRA accounts or income from required minimum distributions from traditional IRAs and other retirement plans. Simply put, losses from a taxable account cannot be used to reduce the taxes owed from the withdrawal of funds from a tax-deferred account (such as a traditional IRA or a 401(k)). In the same way, losses in tax-deferred accounts are not allowed to be used to offset gains in taxable accounts. It’s neither here nor there that the retirement accounts swelled only because the securities they held appreciated.
How Much Can Be Deducted?
Capital gains can be offset by capital losses realized during the same tax year, up to the total amount of capital gains. It does not matter whether the gains and losses are a mixture of short- and long-term, a capital loss can be used to offset a capital gain. If net capital losses exceed capital gains, how much tax relief becomes available for 2010? Section 1211 blesses offsets of net losses against as much as $3,000 of ordinary income—a wide-ranging category that includes salaries, pensions, interest and “dividends” (considered interest) earned on savings accounts, certificates of deposit or similar savings vehicles, Roth conversions and required distributions from tax-deferred plans. If necessary, however, investors can carry forward unused losses over $3,000 into 2011 and succeeding years.
An example: Joe and Barbara Fontana expect to have long-term losses of $60,000 and long-term gains of $40,000, resulting in a net long-term loss of $20,000 for 2010. On Form 1040’s Schedule D, they subtract $3,000 of their loss from ordinary income, leaving them with a carryforward of $17,000 from 2010 into 2011. On the Fontanas’ 2011 Schedule D, they use the remaining loss (unless offset by capital gains) to trim ordinary income by up to $3,000, leaving them with a carryforward of $14,000 from 2011 to 2012. Table 1 shows the math.