When securities markets swoon and apprehensive investors bail out of their holdings, they console themselves with deductions for capital losses at Form 1040 time. But it’s important for investors to be aware that long-standing rules limit their write-offs for losses on sales or redemptions of shares of individual stocks, bonds, mutual fund shares or ETFs, exchanged-traded-funds that trade throughout the day like stocks.
The big hurdle is Internal Revenue Code Section 1211, which caps the deduction at $3,000 for both married couples filing joint returns and single persons — $1,500 each for married couples filing separate returns. These dollar limits have not 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 them to fully offset capital losses against capital gains on other investments. Investors also fail to take advantage of another significant break. They are entitled to use losses on sales or redemptions of stocks, bonds, mutual funds or ETFs to offset gains on sales of capital assets other than stocks, bonds, etc. This opens 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 Mabel Sennett, who plans to sell her personal residence and anticipates a capital gain greater than the exclusion amount of up $250,000 for joint filers ($500,00 for a couple filing jointly). Ms. Sennett should consider realizing losses on, say, stocks or fund shares, to offset the above-$250,000 taxable part of her gain.
Buried in the tax code’s fine print is a provision that bars offsets of capital losses against “qualifying dividends” — IRS-speak for dividends that are taxed at a top rate of 15 percent. It matters not that this rate is the same as that for capital gains.
Another constraint proscribes offsets of capital losses against income from Roth conversions (money moved out of traditional IRAs and into Roth accounts) or income from required minimum distributions from IRAs, 401(k)s, Keogh plans and other retirement arrangements. It is neither here nor there that the accounts swelled only because the securities they held appreciated.
How much tax relief becomes available for 2008 when net capital losses exceed capital gains? 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) paid 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 2009 and succeeding years.
An example: Joe and Norma Gillis 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 2008. On Form 1040’s Schedule D, they subtract $3,000 of their loss from ordinary income, leaving them with a carryover of $17,000 from 2008 into 2009. On 2009’s Schedule D, the Gillises use the remaining loss (unless offset by capital gains) to trim ordinary income by up to $3,000, leaving them with a carryover of $14,000 from 2009 to 2010.