As a result of the recent volatility on the stock market, I’ve received a bunch of questions about claiming losses on individual tax returns. What’s been made clear is that there are a lot of misperceptions floating about… I thought I’d try and set some things straight. To keep it simple, I’m going to focus on capital gains and losses as they apply to stocks – we can talk about homes, art, and other assets later.
First, some quick vocabulary:
Basis. Your basis is generally equal to the original cost of the shares. If you participate in a DRIP or other reinvestment plan, your basis is your cost plus the cost of each subsequent purchase/reinvestment. If you inherit shares, your basis is generally the value of the stock on the date of death. If you receive shares as a gift, your basis is the basis of the donor (sometimes called “carryover basis”).
Taxable event. A taxable event is a sale of stock, death of an owner, or another event that is said to trigger a tax consequence.
Realized gain/loss. This is the important bit. A gain or loss has to be realized in order to mean anything and this is where some taxpayers get confused. Just because the market goes up or down – as it is want to do – doesn’t mean anything. Even if your stocks tumbled hundreds or thousands of dollars in this latest roller coaster ride, it means nothing unless one of those taxable events, mentioned above, happened. Did you sell the stock? Did someone die holding those stocks? If not, then relax, because, for tax purposes, nothing has happened. Simply holding onto the stock during a volatile market does not equal a taxable event, and thus there’s no capital gain or loss.
A quick example:
You buy a stock for $10. It climbs to $20. You continue to hold the stock. Result? No capital gain.
The stock takes a hit and falls to $15. No capital loss.
The stock takes a hit and falls to $7. You continue to hold the stock. No capital loss.
The stock tumbles to $4. You finally get rid of it. You have a capital loss… But how much?
A capital loss is your net selling price less your basis (the formula for calculating capital gain is the same).
Your capital loss is thus $4 – $10, or a loss of $6. You take the loss at the basis, not the high price; the $20 high value is meaningless for purposes of capital gain or loss. That seems to be the sticking point for many taxpayers. You want it to mean something. But it doesn’t.
Schedule D. You’ll report your gains and losses here, and then transfer the results to the reconciliation page on your federal form 1040.
Short term gains or losses. If you hold the shares for one year or less and then sell or otherwise dispose of the stock, your capital gain or loss is considered short-term.
Long term gains or losses. If you hold the shares for more than one year before you get rid of them, your capital gain or loss is called long-term. The highest tax rate on a net long term capital gain of regularly traded stock is 15%.
Net gain or loss. More or less, you add up your gains and subtract your losses to determine your net gain or loss. That figure helps you calculate the applicable tax.
If your gains exceed your losses, you have a capital gain that is taxable (the rate will be dependent on whether it’s long term or short term).
If your capital losses exceed your capital gains, you have a capital loss. You can claim up to $3,000 (or $1,500 if you are married filing separately) of capital losses in any tax year. The loss offsets your taxable income, meaning your other sources of income like wages, for the current tax year.
Loss Carry-forward. If your losses exceed the allowable limits for any tax year, you can carry the loss forward to later years.
So that’s a quick primer on capital gains and losses for shares of stocks. There are a bunch of “what ifs”, exceptions for small businesses and other special circumstances, and extra questions related to calls, puts, and straddles. Since the point of this post is to just hit the basics, I’m skipping over those special situations for now. I may come back to them if there’s some interest, just let me know.
And remember, don’t guess when it comes to this stuff. The consequences can be significant. If you have a question, ask your tax professional – not your broker, not your banker, not your financial advisor (trust me on this).