Capital losses are valuable even though they represent an investment that has lost money. Obviously, no one purchases investments hoping that they will go down in value. However, the markets are inherently volatile. Investments often go down in value, up again, down again, up and down a few more times, and then eventually stay up.
Tax-loss harvesting is the strategy of selling something during one of those down movements to save money on taxes.
Realized capital losses are paired against realized capital gains on your tax return for the year. If you have realized a net gain, it is taxable at qualified income rates. If you have realized a net loss, you are permitted to deduct up to $3,000 on that tax return and carryover the remainder to offset or deduct next year.
If you are utilizing some of the strategies to avoid paying capital gains tax, it is very likely that you can build up a significant capital loss carry forward. This can make investors ask: What should I do with my loss carry forward? Here are your options.
1. Do nothing and take the $3,000 annual tax deduction.
Each year, you are allowed to take $3,000 of your capital losses as a deduction against your ordinary income, and the amounts that remain in the carry forward can be carried forward indefinitely throughout your lifetime.
In this way, your capital loss carry forward changes what would have been a deduction at qualified capital gains into a deduction at the higher ordinary income tax rates. This is a small benefit but it is a helpful one.
By default, we recommend that investors do nothing and take the deduction. Unless there is a compelling reason to do something else, this is what you should be doing.
2. Offset necessary capital gains.
There are times when you have to realized capital gains. You may be forced to realize capital gains because a fund closes or your holdings are subjected to a mandatory tender offer. You may want to realize gains because you need to withdraw from your taxable account or an alternative cheaper, better fund is opened. You may benefit from realizing gains to trim a position over its targets. You may even have realized gains outside of your investments, like real estate sales , which can be offset by the carry forward.
Regardless of the reason, your capital loss carry forward is a buffer against taxation when exiting highly appreciated assets.
3. Never “just because I have it.”
Using up a capital loss carry forward just because you have unrealized capital gains is simple but useless.
Think of your capital loss carry forward as an asset you have banked which provides a defensive buffer for your future taxes. Throwing it away on needless gain realization wastes the value you’ve saved in it.
Capital losses are valuable if you use them properly.
Photo by Adolfo Félix on Unsplash. Image has been cropped.
