The wealthy often use the complex strategy of writing off investment losses on their taxes to evade a large tax bill and keep more of their profits — but how do they do it?
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Capital gains, which are taxed at 15-20% depending on your income, are calculated as a net gain. This means after gains and losses, what the total gain is. Let’s say you made $100 profit on Stock A and lost $50 on Stock B, only $50 total would be considered taxable income. Also called a capital loss, this can be thought of as selling a stock for less than the original price you purchased it for. This loss can be used to reduce the tax burden of future capital gains taxes, which effectively reduces the size of the taxable amount.
Writing off, or deducting, capital losses from your taxes allows investors to get back at least some of their losses by way of tax returns. A great thing about writing off investment losses is that if no capital gain is realized at all during the year, you can write off capital losses to offset your regular taxable income as a regular deduction as well — it does not only count towards investment income.
While this sounds genius — why not just keep writing off losses and play the stock market as much as you want — the maximum deductible loss amount for any given year is $3,000. The good news is that you can roll over unused losses from one year to the next, meaning if you hit a huge loss one year, you will eventually be able to offset the whole loss over the course of several years.
In order to deduct your losses, you will need to fill out Form 8949 on Schedule D of your tax return.
When to write the loss off is where the actual strategy lies. When an investor begins to write off losses, “like” losses will be counted first. This means that long-term capital losses will offset long-term capital gain first, and if there are losses still left over, will then be used towards the short-term losses.
In order to claim a loss, the loss has to be “realized” meaning the stock needs to be sold. Many investors strategically plan what time of the year to realize the loss in order to maximize their savings. For example, investors will wait until the end of the tax year to sell their losing investments in order to save as much as possible. This process is called tax-loss harvesting, and Thomas Schulte, CFP and financial planner at U.S. Wealth Management explains that “this type of tax planning strategy allows loss carryforwards that can be used strategically in future years to offset gains in particularly challenging tax years for an investor.”
He adds that loss harvesting can be extremely beneficial when there are concentrated positions in a portfolio and for the management of the associated risk of such positions.
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The IRS has limitations on how this can be done. You cannot sell a security and repurchase it within 30 days. This is called a wash sale, and the wash sale rule is put in place to make sure people are not loss harvesting every asset simply to realize an overall gain.
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