Capital Assets, Investment Losses & Tax Treatment

Right off the bat, let me clarify that this will not be an exhaustive discussion of the topic of the tax treatment of investments in general as there are countless books, websites, radio programs, college classes and other educational opportunities devoted to the vast depth of that topic.  Instead I want to limit this to touching on the topic of capital assets and in particular the tax treatment of capital losses.

You may be asking what is a capital asset?  Almost everything you own is a capital asset as defined by the Internal Revenue Service (see here for more info), that is used for personal or investment purposes. Examples of capital assets include your personal auto, your house, a second home, stocks, bonds, mutual funds.  

Determining the type of asset is important, as there may be tax benefits for selling investment assets at a loss.  Personal items that are sold at a loss do not provide a tax benefit as there was no motive to make money or a profit on the purchase, for example your personal automobile (unlike collectors that sell cars at the Barrett Jackson's auction).

Now we have defined capital asset and let's assume that you sell that asset (stock, mutual fund, real estate), how do you determine if it was a gain or a loss on the sale?  To determine, you must determine your cost basis in the asset, this will generally be the price paid to acquire the item (plus any allowed carrying costs or other expenses that get added as basis).  You subtract that cost basis from the sale price, deduct any expenses for selling the item (commissions, for example) and the net result is either your gain or loss.

If you calculate the result and have a loss, what next?  For tax purposes, you can deduct a capital loss on your tax return up to certain limits, losses are first offset by any capital gains and then any excess is limited to $3,000 per year.  That $3,000 loss can offset any other type of income, so that is nice but what happens if you have a loss of $100,000?  The loss can be taken until used up, subject to the limits just explained (to offset other capital gains and then up to $3,000 per year).  The time expiration to these carryovers is that when you pass away, the losses are die with you.

I had a discussion recently with a colleague/client about his excessive loss carryover (he has enough losses to last a few hundred years) about strategies to use up those losses.  His potential solution was to invest in a mutual fund that has large capital gains distributions, except mutual funds treat short term capital gains as ordinary income (dividends) and not as capital gains.  So in this case, the $3,000 per year limit would still be applicable.  My suggestion was an investment partnership that would report short term and long term capital gains in a way that would allow for the offset against capital loss carryovers.  I am hoping that he can find a investment that would allow for this treatment.

Do you have tax questions about investment income?  Please shoot me any questions or comments.