Understanding and deducting a stock loss

It’s no fun losing money in the stock market. But it does come with a silver lining: You get to deduct your losses. Don’t get too excited, though, because this deduction is strictly limited.

The first thing to know: When do you suffer a loss?

You only suffer a loss or realize a gain for tax purposes when you sell stock or other investment assets. No matter how much your stocks decline, you have no damage to your taxes until you sell them for a loss.  

Likewise, no matter how much your stocks go up in value, you have no taxable gain until you sell them.  

In short, paper gains are not taxable, and paper losses are not deductible.

Also, don’t worry about gains or losses on stock and other investments you hold in retirement accounts, such as your IRA or 401(k). You need not report on your tax return gains or losses on stock and other investments inside these accounts.

Stocks are capital assets

Stocks fall into a select tax category recognized as “capital assets.” Most of the other investment property you own is also a capital asset. This category includes your mutual funds, bonds, land held for investment, and collectibles like art, and stamps and coins.

Special capital gains tax rates apply to profits you make when you sell long-term capital assets for a profit. These are lower than the tax rates on ordinary income, like salary income you earn from your job.

Special tax rules also apply when you sell stock or another capital asset for a loss. These rules limit how much you can deduct your capital loss from other ordinary income.

How much is your loss?

Understandably, you calculate your loss when you sell stock by subtracting what you paid for it from what you sold it for.

In tax parlance, you subtract the share’s “adjusted basis” from the sales price. The adjusted basis is the amount you paid for the stock plus brokerage fees and any other fees.

For example, if you purchased 100 shares of stock for $1,000 plus $50 commission, your adjusted basis if $1,050. If you sell the stock for $950, you have a $100 loss.

Sometimes, publicly held corporations increase the number of their outstanding shares by doing a stock split. For example, in a 2-for-1 stock split, you get an additional share for each share you own. This change affects the adjusted basis of your stock. In a 2-for-1 split, there will be twice as many shares, so each share’s basis goes down by fifty percent.

Brokers file IRS Form 1099-B, Proceeds from Broker and Barter Exchange Transactions with the IRS each year to report the sales proceeds from stock sales. You also get a copy. The form will show the adjusted basis in your stock as well as its selling price.  

Short-term vs. long-term capital losses

The tax treatment of the gain or loss on the sale of stock depends on its holding period.

If you own a stock for more than one year when you sell it, you have a long-term capital gain or loss.  

If you own a stock for one year or less when you sell it, you have a short-term capital gain or loss.

You need to keep long-term, and short-term capital gains and losses separate.

Short-term losses and gains: Add up all your short-term gains to get your total short-term gain for the year. Do the same thing with your short-term losses. Then subtract the total loss from the total gain. If the losses exceed the gains, you have a net short-term capital loss.  

If the losses are less than the gains, you have a net short-term capital gain. Such an increase gets added to your other income and taxed at the same rate as if it were ordinary income.

Long-term losses and gains: Do the same addition and subtraction for all your long-term capital gains—that is, the stock you owned for more than one year before you sold it. The total is your long-term capital gain or loss.

If you have a long-term capital gain, it gets taxed at the special long-term capital gains tax rate. This rate is 0%, 15% or 20% depending on your taxable income and filing status. It’s usually lower than ordinary income rates.