Notably, you can use a loss to lower the amount of a gain you had earlier in the year that would have been subject to a high ordinary income tax rate if you hadn’t realized it.
Taxpayers can use their capital losses from this time of year to offset up to $3,000 of their ordinary income and capital gains. However, do not be greedy. In a recent case, Powell, TC Sum. Op. 2022-19, 9/26/22, a couple unsuccessfully attempted to use language in the tax return instructions to their advantage in order to deduct a six-figure loss from ordinary income.
The basic premise is that capital gains and losses are classified as short-term gains or losses if you own the asset for less than a year and long-term gains or losses if you own it for more than a year. “netting” gains and losses are used to calculate your tax return’s final results.
After adjusting for capital gains, if you still have a capital loss for the year, you can use the excess loss to reduce up to $3,000 of highly taxed ordinary income. The highest rate of regular income tax is currently 37%. If there is still an excess loss, it is carried over to the following year, and so on. In other words, substantial capital losses realized in 2022 may be used to offset substantial capital gains in 2023 and subsequent years.
Investors frequently try to time the sale of securities to maximize their tax benefits as the year ends. Notably, you can use a loss to lower the amount of a gain you had earlier in the year that would have been subject to a high ordinary income tax rate if you hadn’t realized it.
The new case involves a computer programmer and his wife, both of whom live in Ohio. In 2017, they submitted a joint tax return.
The couple reported the following on their 2017 tax return: $61,234 in wage income, $953 in taxable interest, $245 in ordinary dividends, $38,392 in taxable distributions from individual retirement accounts, $10,112 in unemployment benefits, $13,982 in Social Security benefits, of which $11,885 was reported as taxable, and a $123,822 long-term capital loss. Schedule D was used to report the capital loss.
As a result of the capital loss, the taxpayers reported a 2017 adjusted gross income (AGI) of $1,001. They requested a refund of the federal income tax withheld from their pay of $10,873 because they did not report any taxable income. They were later informed by the IRS of a mathematical error, though. Their 2017 Form 1040 was modified to set a $3,000 cap on their capital loss. The case was heard in Tax Court.
The taxpayers noted that the Schedule D instructions state to enter the lesser of their $123,822 loss or the $3,000 limit. They contended that because both numbers were negative, the massive capital loss was actually the smaller of the two. The IRS responded by citing language indicating that both numbers should be treated as positives.
Unsurprisingly, the Tax Court ruled in favor of the IRS. It limited the loss to $3,000 and stated that any excess could be carried forward.
Lesson learned: Don’t try to defy the system. The IRS will not budge from long-held principles, and you are unlikely to win in Tax Court on these types of issues.
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