Taking a Loss
In the wake of 2002ÔŅĹs dismal market performance, with grief, you may have discovered that your portfolio endured quite a few more losses than gains. Take some consolation knowing that if you have sold a capital asset for less than its original cost, you may have a capital loss that can be deducted on your 2002 tax return.
Capital losses are deductible in full against capital gains. If you have no gains, you may deduct up to $3,000 of ordinary income, thereby still reducing your tax liability. You must determine whether you have sold a capital asset, calculate your cost basis, and know the holding period to calculate your losses. If held for one year or less, losses are treated as short-term and reported in Part I of Schedule D on your 1040. Conversely, If held for over one year, they are long-term and reported under Part II of Schedule D.
There is a significant distinction between tax treatment on the sale or exchange of certain capital assets when sold at a loss. A capital asset is almost anything you own and use for personal purposes or investments (see Capital Gains). But, while your personal residence, car, jewelry, furniture, art, coin or stamp collections are entitled to special tax treatment when sold at a gain, the reverse is not true. Profits on these items are taxable, but losses do not incur any tax deduction. Losses on stocks, bonds, mutual fund shares, and land held for investment use purposes, however, are deductible.
Calculating the basis for mutual fund shares is often the source of much confusion, since shares are purchased at varying prices and times. Organized record keeping is key. There are four methods acceptable to the IRS to make the calculation.
- Average Cost (single category). Most mutual fund companies use this method. Cost basis is the average cost per share of all shares owned. To determine whether you have short or long-term gain/loss, this method assumes your oldest shares are sold first. Once this technique is elected, you cannot switch without IRS permission.
- Average Cost (double category). Shares are separated into two categories ÔŅĹ those held for a year or less and held for longer. Each group is calculated using average cost. When you sell shares, you must indicate whether selling from short or long term holdings.
- Specific Identification Provides the most flexibility and opportunity to minimize taxable gains. You specify which shares you want to sell, using their original price as your cost basis.
- First In, First-Out (FIFO). Requires you to sell your longest-held shares first, which often have the most gain. If not specified, the IRS assumes this method.
If some investments were sold at losses that exceed overall gains, you may deduct either the lesser of $3000 ($1500 if married and file a separate tax return), or your capital losses calculated on form 1040 line 18, Schedule D. If the amount exceeds this yearly limit, you can carry over the unused part to later tax years until it is completely used up.
Generally you are allowed to carry over capital loss to the next tax year when your net loss is more than the yearly limit, or your taxable income without your deduction for exemptions is less than zero. If either of these two scenarios apply, complete a Capital Loss Carryover Worksheet, (instructions in Schedule D of form 1040) to calculate your carry over amount. In 2003, you will treat the carryover loss as if it occurred that year, and it will be combined with any 2003 capital gains and losses. Any net loss will still be subject to the 2003 limit.
Carried over capital loss retains its original character, either long or short-term. Thus if you carry over short-term loss its added to the next yearÔŅĹs short-term losses. Carried over long-term capital loss reduces the yearÔŅĹs long-term gains before itÔŅĹs short-term gains. If you have both short-term and long-term losses, your short-term losses are applied first. Then, if you still havenÔŅĹt passed the yearly deduction limit, you can apply your long-term losses. While notably a bit confusing, the distinctions are important to determine how to apply the deduction against capital gains and reduce the amount of overall tax owed.
Modification of the tax laws can always be anticipated. For further assistance with preparing your returns, and clarification on current rules, the IRS offers ample resources including answers to numerous FAQÔŅĹs on its website, along with several free publications. It is also recommended that you contact your tax advisor for comprehension of complicated tax issues.
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