In investing, not every trade will be a winner. You suffer a capital loss when you close out an investment for less than its acquisition price. The good news is that capital losses reduce your taxes. The bad news is that if you have too many losses, you might have to wait to take advantage of part of the tax deduction.
At Global View, we meet with investors who have experienced big losses in the past. Many times, an “advisor” will offer investing advice that works during bull markets. But it’s not always a bull market, and unfortunately investors can lose a lot when the market changes. Sometimes a loss can be recovered, but often times, it’s money lost that you can’t make back.
Many times, these losses are because investors were advised to take too much risk in their portfolios. When creating a financial plan, a financial advisor should ask about your entire situation to establish your appropriate risk tolerance (it may not be what you thought) and discuss your long-term goals. Not all SC investment advisors are the same. To ensure you’re getting the best advice for your situation, make sure your advisor is a fee-only fiduciary who understands the rules and regulations of the state in which you live.
With appropriate diversification, you can better position yourself to withstand market events.
What is investment loss anyway? Here are a few things you should know.
Realized Vs. Unrealized Loss
You realize a loss when you close out an investment for less than it cost to open it. Until you close out an investment, any loss you have is unrealized. In most cases, you do not report unrealized losses on your taxes, but rather wait until you realize the loss. However, certain types of trades, such as Section 1256 contracts (discussed below), require you to realize your losses at the end of the year.
Figuring Capital Gains and Losses
When you buy a long position in an investment such as a stock, bond or mutual fund, the amount you pay, including fees and commissions, is the investment’s “cost basis.” When you eventually sell the investment, you’ll receive “sale proceeds,” which is the cash amount of the sale minus any commissions. Your capital gain or loss is equal to the sale proceeds minus the cost basis. If you hold the investment for longer than one year, your capital gain or loss is long-term, subject to lower tax rates.
You open a short position by borrowing securities and selling them on the open market. You eventually buy the securities back and replace the loan. If you buy them back for more than the original short sale proceeds, you take a capital loss.
In January, you should receive a copy of Form 1099-B, listing all your short- and long-term capital gains and losses.
The IRS taxes short-term capital gains at your ordinary tax rate. Long-term capital gains tax rates are 0, 15 or 20 percent, depending on your marital status and Modified Adjusted Gross Income (MAGI).
If your capital losses exceed your capital gains, you can deduct up to $3,000 of the losses against your ordinary income. If that leaves you with unused capital losses, you can carry them forward to future tax years and deduct them then. When you use up your carryover losses, apply short-term losses first.
Losses on Futures Options
A futures option gives the holder the right, but not obligation, to purchase (via a call) or sell (via a put) a particular futures contract before the option expires. The cost of the option is called the premium. You report profits and losses from futures options as either long-term or short-term capital gains/losses. Since you typically hold options for under a year, losses are usually treated as short-term capital losses. However, the IRS has special rules that may allow you to reclassify a portion of your short-term capital losses as long-term.
The IRS added Section 1256 to its rules to simplify the tax reporting of gains and losses on certain contracts, including non-equity options such as options on futures. At year’s end, Section 1256 contracts must be marked to market: Any gains or losses are realized on the last day of the year just as if the security was sold on that day and immediately repurchased.
Carryback Losses for 1256 Contracts
A carryback loss is the retroactive application of a loss to previous years’ gains, thus reducing taxes on those gains. For 1256 contracts, the losses you carry back to any of the previous three years cannot exceed the 1256 contract gains for that year – you cannot use a carryback loss to establish a net operating loss for a year. You absorb losses first to the earliest carryback year and then apply any remainder to the following two years. In each carryback year, 60 percent of loss is long-term, the remainder short-term.
Carryforward Losses for 1256 Contracts
If you have an unabsorbed balance after carrying back your current 1256 contract loss over the previous three years, you can carry forward the balance into the next year. Carryforward losses are also subject to the 60 percent long-term/40 percent short-term split. Such losses are the lesser of the net gains and losses on only 1256 contracts or the capital loss carryforward figured without benefit of section 1256 treatment.
Working with a financial advisory firm that offers tax planning services can be a huge benefit to your overall financial plan.