Capital Losses versus Ordinary Losses

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Updated for 2012

Capital Losses versus Ordinary Losses

For tax purposes, the terms capital loss and ordinary loss have specific meanings. A different tax treatment applies to each type of loss.

An ordinary loss is 100% deductible in the year incurred. The deduction for a net capital loss is limited to $3,000 per year.

Capital losses:

A capital loss results when you dispose of a capital asset (e.g., stocks and bonds) for less than your cost.

Capital loss deduction limitation:

Each tax year, capital losses must first be deducted from capital gains (if any).

Then, if net capital losses exceed net capital gains you may deduct up to $3,000 of the excess loss from other income reported on Form 1040 (e.g., wages you or your spouse earned, interest, dividends, etc.).

If net capital losses exceed net capital gains by more than $3,000, the excess over $3,000 must be carried over to the following tax year.

A capital loss that is carried over to the next tax year is included in the calculation of net capital gains and losses of that year.

The same procedure is followed each year for capital losses.

Example:

Deducting a capital loss:

You sold 1,000 shares of XYZ stock and incurred a capital loss of $5,000.
You sold 100 shares of ABC stock and realized a capital gain of $1,000.
The capital loss and capital gain are both short term.
You received a Form 1099-B substitute statement from your broker showing the details of your transactions. The broker acknowledged reporting the cost basis to the IRS for XYZ stock but did not report the cost basis to the IRS for ABC stock.
You're self-employed as a marketing consultant.
You realized a $10,000 net profit from your consulting business.

Reporting Your 2012 Net Capital Loss:

Before getting to how you would report these transactions, some explanation may be needed because of the introduction of a new IRS form in 2011, Form 8949, Sales and Other Dispositions of Capital Assets.

Prior to the introduction of IRS Form 8949 in 2011, capital asset transactions, such as the sale of stocks and bonds, were entered directly on Schedule D.

Beginning in 2011 and beyond, when Form 8949 was introduced, instead of entering capital asset transactions directly on Schedule D, you must now enter them on Form 8949. Then, you carry the results to Schedule D.

Purpose of Form 8949:

First, it provides two sections - one section for entering the details of transactions for short-term capital gains and losses and a second section for entering the details of transactions for long-term capital gains and losses.

Second, in 2011, the IRS began having brokers assist their clients in figuring gains and losses by having brokers report the "cost basis" of capital assets disposed of to the client and the IRS.

Brokers report capital asset transactions on Form 1099-B or, more commonly, on a substitute statement. The IRS, via Form 8949, also wants you to acknowledge if the cost basis for transactions was or was not reported on Form 1099-B (or substitute statement) and, in addition, whether you had any capital asset transactions that were not reported to you on Form 1099-B.

Form 8949 has three boxes in each of its two sections. In each section (which ever section applies to you), you must check one of the three boxes (and only one):

Box A - The broker reported the cost basis on Form 1099-B to the IRS
Box B - The broker did not report the cost basis on Form 1099-B to the IRS
Box C - Capital asset transactions were not reported to you on Form 1099-B.

So, it's possible for a taxpayer to have to file three separate Forms 8949 covering each of the above three situations.

For example, you would prepare one Form 8949 listing those transactions where the cost basis was reported, another Form 8949 listing those transactions where the cost basis was not reported, and a third Form 8949 listing capital asset transactions where you did not receive a Form 1099-B or substitute statement.

Continuing with the reporting part of the example:

For XYZ stock: Prepare Form 8949 reporting the details of this transaction in Part I and check Box A (the cost basis was reported). Enter the total (the $5,000 capital loss) on line 2 of Part I.
For ABC stock: Prepare a second Form 8949 reporting the details of this transaction in Part I and check Box B (the cost basis was not reported). Enter the total (the $1,000 captial gain) on line 2 of Part I.
For XYZ stock: Enter the amount from line 2 of Form 8949, on line 1 of Schedule D in Part I. (This applies to the transaction where you checked Box A on Form 8949.)
For ABC stock: Enter the total amount from line 2 of Form 8949, on line 2 of Schedule D in Part I. (This applies to the transaction where you checked Box B on Form 8949.)
Enter the net loss of $4,000 on line 7 of Schedule D.
Complete Part III of Schedule D. Here, you would enter the $4,000 net loss on line 16 and line 21. You may only claim $3,000 of the loss.
Enter the $3,000 loss on line 13 of Form 1040 (side note: you would enter $1,500 if you were married filing separately).
On Form 1040, you would subtract the $3,000 loss from the $10,000 net profit from your consulting business.
The excess loss of $1,000 ($4,000 minus $3,000) must be carried over to the following year.

Ordinary losses:

Ordinary losses are not subject to the capital loss rules.

Ordinary losses are fully (100%) deductible in the year incurred against other income reported on Form 1040 (e.g., wages you or your spouse earned, interest, dividends, etc.).

For example, a net business loss incurred by a sole proprietorship (Schedule C or F) is an ordinary loss and is fully deductible from any other income reported on Form 1040.

You simply enter a Schedule C net business loss on Form 1040 and subtract it from other income.

Example:

Deducting an ordinary loss.

You incurred a $10,000 loss in your part-time consulting business (reported on Schedule C).
You earned $30,000 from your regular job.

You may deduct the full $10,000 from your $30,000 salary, reducing it to $20,000.

You enter the business loss of $10,000 on Form 1040 and subtract it from your salary, which is reported on Line 7.

Your tax savings:

If you were in the 25% tax bracket, the $10,000 loss deduction would slash your taxes by $2,500 (25% x $10,000).

Capital Losses: Nine Rules for Capital Losses

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