July 7, 2008 12:00 am

Tax Breaks for Your Investment Losses

In today’s tough economy, investments in personal portfolios, 401(k) plans, and individual retirement accounts (IRAs) may be down. Fortunately, the tax law lets you ease your financial pain by claiming tax breaks for bad investments. But not every loss, no matter how real or how large, is tax deductible.

Capital losses

As you watch the price of the stocks, bonds, and mutual fund shares you own decline, you have a potential loss (called a paper loss). As long as you don’t sell your holding, you don’t have a tax loss; the price of the stocks can go up again while you hold onto your shares. If you ride out the bad times and the price of your holdings recovers, you don’t have any losses to report. Until you sell the stocks or they become totally worthless, you may feel poorer but you don’t have any losses for tax purposes.

When you sell assets held for investment at a loss, you can claim a capital loss deduction. For instance, if you sell stock that has dropped in price since you bought it, you can deduct the loss.

Caution: You can’t take a capital loss deduction for assets held for personal purposes, such as your home, vacation property, or your personal car. And you usually can’t take a capital loss deduction on the sale of assets in your 401(k) or IRA; these are accounts where gains and losses are not currently taxed (they are tax-deferred and losses are allowed only in very special situations).

Capital loss limit. Capital losses can fully offset capital gains for the year. However, if these losses exceed your gains, you can use up to $3,000 of excess capital losses to offset ordinary income, such as your salary or interest income. The same $3,000 limit applies whether you are single or married filing a joint return ($1,500 for married persons filing separate returns).

Capital loss carryover. If your capital losses exceed the amount of your capital gains and the $3,000 ordinary loss deduction, the excess capital losses can be carried forward. There is no time limit for using up these carryover losses. For example, say in the following year after you sold securities for a capital loss you have a capital loss carryover of $10,000 and have no capital gains in that year. You can deduct $3,000 of the carryover against ordinary income, leaving you $7,000 carryover to the succeeding year.

Wash sale rule

You can’t churn your losses solely to obtain tax breaks while maintaining the identical or essentially the same economic position. The wash sale rule in the tax law prevents you from deducting a capital loss when you buy substantially identical securities within 30 days before or after the loss sale.

For instance, if you sell 100 shares of Stock X at a loss on July 7 and buy 100 shares of Stock X on July 21, you can’t take the tax loss from the July 7 sale.

Basis. The loss isn’t lost forever. You adjust the basis of the new lot by adding the loss not taken on the old lot to the basis of the new lot, so that the loss will be realized when the new lot is sold.

Tax-deferred accounts. You can’t sidestep the wash sale rule by selling your losing securities and then causing your 401(k) or IRA to acquire the same or substantially identical securities in the tax-deferred account.

Section 1244 stock

If you’ve invested in a privately held corporation and the business goes under or you sell your stock at a loss, you can treat the first $50,000 ($100,000 on a joint return) of loss as an ordinary loss. Any additional loss is a capital loss subject to the rules previously discussed.

Eligibility. This tax break applies only if you acquired the stock for cash or property. You can’t take a Section 1244 stock acquired for the performance of services or received as a gift or inheritance.

Worthless securities

Stocks and bonds, whether publicly traded or privately held, can lose all of their value. As long as you can show that your securities had some value at the end of the previous year but became totally worthless this year, you can write

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Tax Glossary

Audit

An IRS examination of your tax return, generally limited to a three-year period after you file.

More terms