Financial Tips: Understanding Taxation of Capital Losses

Capital losses are the adverse circumstance that most investors don't like i.e. a loss of capital arising out of the sale of an asset that has lost value. Examples of capital losses include the sale of a home at a lower price than one bought it for, and loss on the sale of stocks. As bad as capital losses are there is actually a good side to capital losses and that has to do with their taxation.

Capital Losses are Tax Deductible:

The best thing about a capital loss is that it's tax deductible. When one loses money through the sale of an asset that has lost money that loss can be deducted of a tax filers annual income. For example, if John Doe earned $51,000.00 in year Y, but also lost $5,000.00 on the sale of his home, he can deduct the $3,000.00 from the $66K making his annual income $48,000.00

Another good thing about the tax deductibility of capital losses is that they may lower one's adjusted gross income to an income tax bracket they would not have been in had they had a capital gain or no capital loss. When one is close to the cusp of tax brackets, capital gains between $1-3000.00 may be redundant since a capital loss of the same amount could save one a similar amount of money in taxes. That is to, say when in the tax cusp sell at a loss to avoid higher taxes.

Illustrating Bracket Taxation:

To illustrate how selling at a loss can be good consider the following example. Since John Doe earned $51,000.00 in year Y, it is looking like he may end up in the 25% tax bracket after deductions. Moreover, without the capital loss, John Doe may only be able to utilize his standard deductions and federal tax exemptions, which can be around $17,000.00 if John Doe has no children and is married filing jointly. This makes is adjustable gross income $36,000 which doesn't qualify for the 15% income tax. However, with the capital loss deduction of $3,000.00, John Doe's income is now only taxable at 15% which is approximately $4650.00 of tax as opposed to $9000.00 at the $36K level. So even if John Doe had a capital gain of $3K or no gain at all, being in the lower tax bracket has saved him around $5000 in taxes which is better than $3000 in capital gains or no gain at all.