Property Used in a Trade or Business

Net Capital Loss Deduction and Loss Carryover Rules

A net capital loss occurs when a taxpayer’s capital losses exceed capital gains for the year.  An individual’s maximum net capital loss deduction in 2020 allowed against taxable income is $3,000 per year.  This tax deduction comes with indefinite carryover until exhausted or netted against future capital gains.

Specific to corporations, they may deduct a capital loss carryover from a current year capital gain when calculating a net operating loss.  However, they cannot deduct a capital loss carryback against a net capital gain to determine a net operating loss for the current year.

In other words, because the $3,000 deduction for net capital losses is only available to individuals and not to corporations, corporations may only use capital losses to offset capital gains.  If an excess capital loss occurs, there is no carryback allowed.

However, as stated above, the taxpayer may use the carry forward of capital losses until exhausted.  Also, the excess capital loss maintains its character as long-term or short-term in future years.  The best tax software will handle any carry forwards if you use the same company’s software each year.

In a non-business environment, in the year in which a personal bad debt becomes worthless, it is then treated as a short-term capital loss.  And remember, in the case of worthless stock and securities, they are treated as capital losses as if they were sold on the last day of the taxable year in which they became totally worthless.

I came very close to taking advantage of this worthless stock treatment on my first set of investment mistakes.  My decision-making was not sound, and led me to the conclusion I am best served by investing in index funds for my portfolio.

Fortunately, I would have been granted some reprieve by having an ordinary loss recognized against my taxable income.  Even under tax reform in 2018, these rules remain in place.

As a final note on net excess capital losses, if individual taxpayers choose the married, filing separately status, this limits the net capital loss deduction to $1,500 per person (half).

Capital Gains Tax Rates

If you have a net capital gain, a lower tax rate may apply to the gain than the tax rate which applies to your ordinary income.  The term “net capital gain” means the amount by which your net long-term capital gain for the year exceeds your net short-term capital loss for the year.

The term “net long-term capital gain” means long-term capital gains reduced by long-term capital losses, including any unused long-term capital loss carried over from previous years.

The tax rate on most net capital gains no longer exceeds 15% for most taxpayers.  Now, most net capital gains receive tax-free treatment if your income falls into the 10% or 12% ordinary income tax brackets.

However, for individuals in the 37% tax bracket and earning more than $434,551 and married, filing jointly taxpayers exceeding $488,851, their net capital gain resides in the 20% tax bracket.

Three other circumstances exist where net capital gains may receive tax treatment at rates greater than 15%:

  1. Taxable part of a gain from selling section 1202 qualified small business stock when taxed at a maximum 28% rate
  2. Net capital gains from selling collectible (such as coins, art, etc.) receive tax treatment at the 28% maximum rate
  3. The portion of any unrecaptured section 1250 gain from selling section 1250 real property will be taxed at a maximum 25% rate (discussed more below)

Netting Procedures

In case you’ve ever wondered whether you can have short term capital losses offset long term capital gains, the Internal Revenue Code outlines specific netting procedures for capital gains and losses.  Essentially, the taxpayer nets gains and losses within each tax rate group (e.g., the 15 percent rate group), creating net short-term and long-term gains or losses by rate group.

  • Short-Term Capital Gains and Losses

The resulting short-term and long-term losses offset short-term and long-term gains (respectively) beginning with the highest tax rate group and continuing to the lower rates.

If short-term capital losses (including short-term capital loss carryovers) occur, they first offset short-term gains, which would have been taxed at ordinary income rates.  The short-term capital loss is then used to offset any long-term capital gains from the next rate group (e.g., collectibles).

The remaining short-term capital loss will then offset any long-term gains from the higher percent group (e.g., unrecaptured Section 1250 gains).  From here, the final short-term capital loss then offsets any long-term capital gains applicable at the lower tax rate group.

  • Long-Term Capital Gains and Losses

In the case of long-term capital gains and losses (including those long-term capital loss carryovers) from the highest rate group, they first offset gains from the highest rate group and then against net gains from the 15 or 20 percent rate group.

If there are long-term capital losses from the 15 or 20 percent rate group, they first offset net gains from the higher group.

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