Capital Loss

A capital loss is the amount by which the adjusted basis of a capital asset exceeds what you received for it on a sale or exchange. Like a capital gain it requires a realization event, so a holding that has fallen in value produces nothing until you dispose of it, and it takes its short-term or long-term character from how long the asset was held.

The important thing about capital losses is that existing and being deductible are two different questions, and the second is governed by a section most readers never encounter. IRC 165(a) allows a deduction for any loss sustained during the year and not compensated by insurance or otherwise. IRC 165(c) then limits that, for an individual, to three things: losses incurred in a trade or business, losses incurred in any transaction entered into for profit though not connected with a trade or business, and, subject to further restrictions, losses of property not connected with either, arising from fire, storm, shipwreck or other casualty, or from theft.

Investments sit squarely in the second category, which is why losses in a brokerage account are deductible and why the question rarely arises for investors. It arises constantly for everyone else.

The asymmetry between gains and losses on personal property is the single most useful thing on this page. IRC 1221 makes your car, your furniture, your boat and your home capital assets, because it defines a capital asset by exclusion and personal-use property is not one of the excluded categories. So a sale at a profit produces a taxable capital gain. But a sale at a loss was not a transaction entered into for profit and was not connected with a trade or business, so IRC 165(c) allows nothing, and the loss is simply absorbed.

Sell a car for more than its adjusted basis and there is a gain to report. Sell it, as almost everyone does, for less, and there is no deduction. The same applies to a personal residence sold at a loss, which is a genuinely expensive surprise in a falling market and which people reasonably expect to work like a stock. It does not.

The third limb of 165(c), casualty and theft, is narrower than its wording suggests and has been for some years. Under IRC 165(h)(5) a personal casualty loss in a taxable year beginning after 2017 is deductible only to the extent it is attributable to a federally declared disaster, and for taxable years beginning after 2025 the provision also reaches a state declared disaster. So ordinary bad luck, a fire confined to one house or a theft from one garage, is outside the deduction even though the statute's opening words appear to reach it. There is an exception measured against personal casualty gains: if you have such gains for the year, a loss that is not attributable to a declared disaster is still allowed up to the amount of those gains.

The netting order is a sequence, not a subtraction, and it decides how much a loss is worth. The definitions in IRC 1222 do the sorting. Short-term losses are first set against short-term gains, and long-term losses against long-term gains, producing a net figure of each character. Only then do the two results meet, and only if one is a gain and the other a loss.

The practical consequence is that a short-term loss and a long-term loss of the same size are not equally useful, because they are applied first against different things. A short-term loss goes first against short-term gains, which are taxed as ordinary income, while a long-term loss goes first against long-term gains, which are not. Which of the two you happen to hold therefore affects what the loss is worth before any strategy enters the picture.

After the netting, the statute lets a limited amount of the remainder reach ordinary income. IRC 1211(b) allows losses from sales of capital assets only to the extent of the gains from such sales, plus, if the losses exceed the gains, the lower of $3,000, or $1,500 for a married individual filing a separate return, or the excess of the losses over the gains. Those dollar amounts are fixed in the statute, contain no inflation adjustment, and have not been changed since 1986, so unlike most figures in the tax code they are the same number every year.

What is left over does not expire. IRC 1212(b) carries the excess into the succeeding taxable year, and it does so with the character preserved: an excess of net short-term capital loss becomes a short-term capital loss next year, and an excess of net long-term capital loss becomes a long-term one. For an individual there is no time limit and no expiry, so a large loss can be released against gains and against ordinary income over as many years as it takes. The mechanics of tracking that carryforward across years have their own page.

Losses only exist where the tax system is looking. Inside an IRA, a Roth IRA, a 401(k) or any other tax-advantaged account, gains and losses are not reported on the annual return, so a holding that falls in value there produces no deductible loss no matter how large the decline. The deduction lives entirely in taxable accounts, which is also the reason tax-loss harvesting, the deliberate realization of losses as a strategy, is confined to them.

You sell a capital asset for less than its adjusted basis, producing a loss with a short-term or long-term character. At year end, losses are netted against gains within each character, the two results are then combined, and any remaining loss reduces ordinary income up to the statutory limit. Whatever is still unused carries forward into the next year with its character intact.

A hypothetical example of the netting order. In one year Tomás realizes a $4,000 short-term gain, a $9,000 short-term loss, a $6,000 long-term gain and a $1,000 long-term loss.

Within each character first. Short-term: $4,000 − $9,000 leaves a net short-term loss of $5,000. Long-term: $6,000 − $1,000 leaves a net long-term gain of $5,000.

Now across. The $5,000 net short-term loss offsets the $5,000 net long-term gain exactly, leaving zero. Tomás reports no capital gain and takes no capital loss deduction. He also carries nothing forward, because nothing remains.

Change one number and the rest of the machinery becomes visible. Suppose the short-term loss had been $16,000 rather than $9,000. Net short-term is then a loss of $12,000 ($4,000 − $16,000), which against the $5,000 net long-term gain leaves an overall loss of $7,000. Of that, $3,000 deducts against his ordinary income this year under IRC 1211(b), and the remaining $4,000 ($7,000 − $3,000) carries forward into the next year as a short-term capital loss, because that is the character the excess came from.

Pros

• Losses offset gains dollar for dollar without limit, so a bad year in one holding genuinely reduces the tax on a good year in another.
• A limited amount reaches ordinary income each year, which is taxed at higher rates than capital gains, so the deduction can be worth more than its size suggests.
• The carryforward has no expiry for an individual and keeps its character, so a large loss is not wasted by being too big to use at once.
• The netting rules are mechanical and objective, so the result rarely depends on judgment.

Cons

• Losses on personal-use property are not deductible at all, while gains on the same property are taxable, which is the least intuitive rule in the area.
• The annual deduction against ordinary income is capped at a figure that has not moved since 1986, so a large loss can take many years to use.
• Realizing a loss only to buy the same holding back can disallow it under the wash sale rule, and the disallowance can be triggered accidentally.
• No loss exists inside a tax-advantaged account, so declines there produce no tax benefit of any kind.
• The casualty limb is confined to declared disasters, so most everyday accidental losses fall outside the deduction.