How to Alleviate the Cap Loss Tax Problem

When securities markets swoon and apprehensive investors bail out of their holdings, they console themselves with deductions for capital losses when it comes time to file taxes. But long-standing rules limit deductions for losses on sales or redemptions of shares of individual stocks, bonds, mutual fund shares, and exchange-traded funds (ETFs). Still, resourceful investors will find ways to work around these limits, if they know the full details of IRS rules.

The big hurdle is IRC Section 1211, which caps the deduction at $3,000 for both married couples and single filers. (Married couples who file separate returns are limited to a maximum deduction of $1,500 per person.) These dollar limits haven’t been revised upward since they went on the books in 1978, when Jimmy Carter was in the White House.

In my experience, many individuals focus just on the $3,000 ceiling and forget that the tax code authorizes them to be resourceful when they incur capital losses. Section 1211 allows capital gains on investments to be fully offset by capital losses on other investments. There’s also another significant break that investors fail to take advantage of: Losses on sales or redemptions of stocks, bonds, mutual funds or ETFs held in taxable accounts can be used to offset gains on sales of capital assets other than stocks, bonds, and so on. This opens up many possibilities—for instance, profits on sales of collectibles and vacation homes.

Take, for example, the case of Marilyn Paul. Marilyn plans to sell her personal residence and anticipates a capital gain greater than the exclusion amount of up to $500,000 for married couples filing jointly or $250,000 for singles and married couples filing separate returns. Marilyn should consider realizing losses on, say, shares of stock or mutual funds to offset the taxable part of her gain.

How much can be deducted?

It depends. The law allows capital gains to be offset by capital losses realized during the same tax year, up to the total amount of capital gains. It doesn’t matter whether the gains and losses are a mixture of short- and long-term; losses can be used to offset capital gains.

Suppose net capital losses exceed capital gains. How much tax relief becomes available for 2014? Section 1211 blesses offsets of net losses against as much as $3,000 of ordinary income—a wide-ranging category that includes salaries, pensions, and interest. If necessary, however, investors can carry forward unused losses over $3,000 into 2015 and succeeding years.

An example: Nat and Patricia Rosasco expect to have long-term losses of $60,000 and long-term gains of $40,000, resulting in a net long-term loss of $20,000 for 2014. On Form 1040’s Schedule D, they subtract $3,000 of their loss from ordinary income, leaving them with a carryforward of $17,000 from 2014 into 2015. On the Rosasco’s 2015 Schedule D, they use the remaining loss (unless offset by capital gains) to trim ordinary income by up to $3,000, leaving them with a carryforward of $14,000 from 2015 to 2016.

Another state of affairs—this one from the pages of my real-life client roster—includes a married couple I’ll call Rudolph and Flavia Colman. Rudy is a 30-something investor with an unshakeable faith in the “market-timing fairy.” Alas and unsurprisingly, Rudy relied on a seer who was no Nostradamus.

Just how maladroit was Rudy at anticipating market movements? In 2000, a few days before the prices of technology stocks crested, he moved money into mutual funds that invested in dot-com ventures—despite his wife’s prescient kvetching to buy bond funds instead. Fortunately for Rudy, Flavia—who has forgotten more about tax planning than her husband will ever know—persuaded her husband to place ownership of the fund shares in both their names. (A little lesson against stereotyping your clients: the tax-savvy Flavia is a former Victoria’s Secret model. I’m a founding member and active member of Flavia’s fan club.)

The Colmans suffered losses of $90,000 when the dot-com bubble burst. In the event that the couple realizes no future capital gains and the cap stays set at $3,000, they’ll write off all of their losses only after the passage of 30—count ’em, 30—years, a number not necessarily daunting, as Rudy is hale and hearty, swims a mile just about every day, and gets 24/7/365 TLC from his devoted spouse.

What if Rudy dies before they’re able to deduct the entire $90,000? Will this be a problem for Flavia? Not at all, provided she lives long enough. After filing their last joint 1040 form, she just continues to claim unused losses in subsequent years on her own returns, whether filed singly or—should she remarry—jointly with her next husband.

So why was it wise for the shares to be owned jointly? Had Rudy been the sole owner at the time of his death, that would’ve derailed her carryforward.