Although having a loss on an investment is not a pleasant proposition, there is a silver lining. Losses from investments may be used as tax deductions if the conditions in the tax law are met. Investors should understand the rules for deducting investment losses when making a decision whether to sell a certain investment.
The Internal Revenue Service (IRS) uses the term capital gains and losses for profits and losses from investments. Capital gains and losses do not become a taxable event until the investment is sold and the gain or loss is realized. If an investor want to use the loss from an investment as a tax deduction the investment must be sold at a loss before the end of the year.
Capital gains and losses are divided into two categories. If the investment was owned for one year or less, the result is a short-term gain or loss. Investments owned for longer than a year and sold result in long-term gains or losses. It is important to keep track of each investment sold. Record then amount of gain or loss and whether it was short-term or long-term.
Investment losses are used to offset investment gains for tax purposes. The IRS rules state that short-term losses must be used against short-term gains and long-term losses against long-term gains. Any excess capital gains of one category can be used against capital losses of the other category. For example, an investor has $20,000 in short-term losses and $15,000 in short-term gains. $15,000 of the short-term losses must be used against the short-term losses and the balance of $5,000 can be used to offset long-term gains. Any capital losses in excess of all capital gains can be used to reduce other income to a maximum of $3,000.
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Losses from investments must be used in the order specified by the IRS as tax deductions. Long-term capital gains are taxed at a much lower rate than short-term gains or ordinary income. Some tax planning before selling investments at a loss can help maximize the use of the deductions. Loss deductions save the most in income tax if they are used against short-term gains or other income. If total capital losses exceed capital gains by more than the $3,000 allowed as a deduction against ordinary income, the balance can be used in future tax years.
If an investment is sold for a loss and then purchased again within 30 days the sale is called a "wash sale" and the loss deduction will be disallowed. An investor cannot sell and investment on December 31 to take the loss and buy it back on January 2. There is no wash sale rule for capital gains. If an investment is sold for a gain, the IRS want its tax on the gain. It does not matter if the investor immediately buys the investment again.