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What is a Capital Loss?
A capital loss is a loss that a company suffers when a capital asset or an investment decreases in value. The company usually does not realize this loss, until when the current selling price of an asset becomes lower than its initial buying price. A capital loss is the difference between an asset’s lower selling price and its higher buying price.
A Little More on What is a Capital Loss
A business can also experience capital losses when it writes off some of its assets, removing them completely from its balance sheet. The business owners might be in debt and may not be able to repay the debt due to various reasons. Individual shareholders in a company who may want to sell their shares or equity can also suffer capital losses from the sales.
A capital loss can either be long-term or short-term depending on the period of the purchase. When a company conducts a transaction within the same year, the capital loss will be short-term. If the company conducts the transaction after more than a year, the capital loss will become long-term. The company defines the period from the day when it buys the asset to the day it sells the asset.
How it works (Example)
The capital loss formula takes the assumption that the selling price of the asset is lower than the buying price. So, when an investor sells an investment at a price higher than the buying price, that is a capital gain.
The formula for calculating capital loss is:
Capital loss = buying price of an asset – selling price of an asset
Take an example of an investor who purchases 200 shares of Company ABC for $10 per share. After four months, the prices of the shares decreases to $5 per share. The value of the investment goes from $2000 to $1000, a capital loss of $1000.
Capital Loss Deduction
If a capital gain is an amount that a business or an investor makes whenever they sell an investment, then any amount they lose is a capital loss. In other words, a capital loss is not profitable or beneficial to a business or an investor. The Internal Revenue Service permits the deductions of capital losses from the investor’s or business’s income up to a certain amount.
IRS allows an investor to deduct losses from investment property only, and not from any personal property they own. Any capital gains from the investments balance out the capital losses that are of the same type.
For instance, short-term gains balance out short-term losses, while long-term gains balance out long-term losses. In case the capital losses are more than the capital gains, then the business deducts it from its tax returns. The limit for deductions on the tax returns is $3,000 per year, $1,500 for the married and are filing returns separately. If the net loss exceeds the deduction limit, the excess loss amount goes to forthcoming tax years.
Capital losses are usually tax-deductible, but that is only possible when the investor or business owner realize the losses. That is, the IRS allows the deductions when the investors sell the assets, or when the law deems the assets as worthless. The IRS thinks of every investment that an investor owns as a capital asset, which is subject to capital loss deductions or capital gain taxes.
How to File and Claim Capital Losses
A business owner or an investor should report all their capital gains or losses on their tax returns. They need to report capital losses and gains on Schedule D and report corresponding amounts on Form 1040. They should also report the carryover losses using the gains carryover record sheet.
Claiming the losses also requires the investor to fill IRS Form 8949, which is the Sales of capital assets form. Although Form 8949 is new, it helps the IRS to compare the brokerage firm’s data to the investor’s tax return form.
Capital Losses and the Wash Sale Rule
The wash sale rule suspends any losses an investor incurs if they buy identical securities 30 days after or before selling the securities at a loss. The rule inhibits an investor from claiming the full loss amount. Assume an investor sells their securities in Company ABC at a loss on April 31. The wash sale rule will apply if they decide to buy the same securities in ABC 30 days after the date, or if they had bought the securities 30 days before.
The period of the wash sale runs from 1 April, or thirty days before to 30 April, being thirty days after the sale. When an investor was to buy securities from ABC during this period, he cannot claim the full loss amount. He/she will have to count the loss together with their cost basis of purchasing the new shares.
Reference for “Capital Loss”
Academic research on “Capital Loss”
Capital gains tax rules, tax‐loss trading, and turn‐of‐the‐year returns, Poterba, J. M., & Weisbenner, S. J. (2001). Capital gains tax rules, tax‐loss trading, and turn‐of‐the‐year returns. The Journal of Finance, 56(1), 353-368.
Non-Pro Rata Stock Surrenders: Capital Contribution, Capital Loss or Ordinary Loss?, Bolding, G. M. (1979). Non-Pro Rata Stock Surrenders: Capital Contribution, Capital Loss or Ordinary Loss?. The Tax Lawyer, 275-287.
Capital Loss Deduction Limits After the Tax Reform Act of 1986, Baker, W. K. (1987). Capital Loss Deduction Limits After the Tax Reform Act of 1986. Tex. L. Rev., 66, 159.
Abandoning Partnership Interests: Ordinary Versus Capital Loss, Moyer, S. (1982). Abandoning Partnership Interests: Ordinary Versus Capital Loss. Neb. L. Rev., 61, 621.
Market equilibrium with capital loss deduction options, Murphy, A. (2001). Market equilibrium with capital loss deduction options. International Journal of Theoretical and Applied Finance, 4(05), 783-803. This research builds on a widely-cited study to prove that the permissible tax loss deduction subsidizes investments in volatile securities by materially lowering the required expected return on more volatile assets. The implications of the theory are robust to the existence of transaction costs, dividends, forced liquidations, and a ceiling on capital loss deductions in some countries. It is further shown that special tax treatment at death significantly increases the value of the tax deduction option. The theoretical model is explained to be consistent with empirical findings reported in the literature and to actually help explain some asset pricing anomalies.