Tax loss carryforward: What is it and how does it work?

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A tax loss carryforward is a special tax rule that allows capital losses to be carried over from one year to another. In other words, capital losses realized in the current tax year can also be used to offset gains or profits in a future tax year.

 

Investors can use a capital loss carryforward to minimize their tax liability when reporting capital gains from investments. Business owners can also take advantage of loss carryforward rules when deducting losses each year.

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Knowing how this tax provision works and when it can be applied are important from an investment tax-savings perspective.

 

Related: What to Know about Paying Taxes on Stocks

 

How Tax Loss Carryforwards Work

In general terms, a tax loss carryforward works by allowing you to report losses realized on assets in one tax year on a future year’s tax return. IRS loss carryforward rules apply to both personal and business assets. The main types of carryforwards allowed by the Internal Revenue Code are capital loss carryforwards and net operating loss carryforwards.

Capital Loss Carryforward

IRS rules allow investors to “harvest” tax losses, meaning they use capital losses to offset capital gains. An investor could sell an investment at a capital loss, then deduct that loss against capital gains from other investments, assuming they don’t violate the wash sale rule.

 

The wash sale rule prohibits investors from buying substantially identical investments within the 30 days before or 30 days after the sale of a security for the purposes of tax-loss harvesting.

 

If capital losses are equal to capital gains, they would offset one another on your tax return, so there’d be nothing to carry over. For example, a $5,000 capital gain would cancel out a $5,000 capital loss and vice versa.

 

If capital losses exceed capital gains, you can claim the lesser of $3,000 ($1,500 if married filing separately) or your total net loss shown on line 21 of Schedule D for Form 1040. Any capital losses in excess of $3,000 could be carried forward to future tax years. The IRS allows you to carry losses forward indefinitely.

Net Operating Loss Carryforward

A net operating loss (NOL) occurs when a business has more deductions than income. Rather than posting a profit for the year, the business operates at a loss. Business owners may be able to claim a NOL deduction on their personal income taxes. Net operating loss carryforward rules work similar to capital loss carryforward rules, in that businesses can carry forward losses from one year to the next.

 

For losses arising in tax years after December 31, 2020, the NOL deduction is limited to 80% of the excess of the business’s taxable income, according to the IRS. To calculate net operating loss deductions for your business, you first have to omit items that could limit your loss, including:

  • Capital losses that exceed capital gains
  • Nonbusiness deductions that exceed nonbusiness income
  • Qualified business income deductions
  • The net operating loss deduction itself

These losses can be carried forward indefinitely at the federal level.

 

Note, however, that the rules for NOL carryforwards at the state level vary widely. Some states follow the federal rules, but others do not.

How Long Can Losses Be Carried Forward?

According to the IRS, tax loss carryforward rules allowed losses to be carried forward indefinitely. That includes both capital losses associated with the sale of investments or other assets, as well as net operating losses for a business. Prior to the Tax Cuts and Jobs Act of 2017, business owners were limited to a 20-year window when carrying forward net operating losses.

 

It’s important to keep in mind that capital loss carryforward rules don’t allow you to simply roll over losses. IRS rules state that you must use capital losses to offset capital gains in the year that they occur. You can only carry capital losses forward if they exceed your capital gains for the year. The IRS also requires you to use an apples-to-apples approach when applying capital losses against capital gains.

 

For example, you’d need to use short-term capital losses to offset short-term capital gains. You couldn’t use a short-term capital loss to balance out a long-term capital gain or a long-term capital loss to offset a short-term capital gain. This rule applies because short- and long-term capital gains are subject to different tax rates.

Example of Tax Loss Carryforward

Assume that you purchase 100 shares of XYZ stock at $50 each. Thirteen months after purchasing the shares, their value has doubled to $100 each so you decide to sell, collecting a capital gain of $5,000. You also hold 100 shares of ABC stock, which have decreased in value from $70 per share to $10 per share over that same time period.

 

Your capital losses would total $6,000 (the difference between the $7,000 you paid for the shares and the $1,000 you sold them for). You could use $5,000 of that loss to offset the $5,000 gain associated with selling your shares in the first company. Per IRS rules, you could also apply the additional $1,000 loss to reduce your ordinary income for the year.

 

Now, say you also have another stock that you sold at a $5,000 loss. You could apply $2,000 of that loss to offset ordinary income, then carry the remaining $3,000 forward to a future tax year, per IRS rules. All of this, of course, assumes that you don’t violate the wash sale rule when timing the sale of losing stocks.

The Takeaway

If you’re investing in a taxable brokerage account, it’s important to include tax planning as part of your strategy. Selling stocks to realize capital gains could result in a larger tax bill if you’re not deducting capital losses at the same time. With tax-loss harvesting, assuming you don’t violate the wash sale rule, it’s possible to carry forward investment losses to help reduce the tax impact of gains over time. This applies to personal as well as business gains and losses. Thus, understanding the tax loss carryforward provision may help reduce your personal as well as investment taxes.

 

Learn More:

This article
originally appeared on SoFi.com and was
syndicated by MediaFeed.org.

SoFi Invest
The information provided is not meant to provide investment or financial advice. Investment decisions should be based on an individual’s specific financial needs, goals and risk profile. SoFi can’t guarantee future financial performance. Advisory services offered through SoFi Wealth, LLC. SoFi Securities, LLC, member FINRA  SIPC  . SoFi Invest refers to the three investment and trading platforms operated by Social Finance, Inc. and its affiliates (described below). Individual customer accounts may be subject to the terms applicable to one or more of the platforms below.
1) Automated Investing—The Automated Investing platform is owned by SoFi Wealth LLC, an SEC Registered Investment Advisor (“Sofi Wealth“). Brokerage services are provided to SoFi Wealth LLC by SoFi Securities LLC, an affiliated SEC registered broker dealer and member FINRA/SIPC, (“Sofi Securities).
2) Active Investing—The Active Investing platform is owned by SoFi Securities LLC. Clearing and custody of all securities are provided by APEX Clearing Corporation.
3) Cryptocurrency is offered by SoFi Digital Assets, LLC, a FinCEN registered Money Service Business.
For additional disclosures related to the SoFi Invest platforms described above, including state licensure of Sofi Digital Assets, LLC, please visit www.sofi.com/legal. Neither the Investment Advisor Representatives of SoFi Wealth, nor the Registered Representatives of SoFi Securities are compensated for the sale of any product or service sold through any SoFi Invest platform. Information related to lending products contained herein should not be construed as an offer or pre-qualification for any loan product offered by SoFi Lending Corp and/or its affiliates.
Tax Information: This article provides general background information only and is not intended to serve as legal or tax advice or as a substitute for legal counsel. You should consult your own attorney and/or tax advisor if you have a question requiring legal or tax advice.

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New to investing? Know these tax basics

 

Taxes on investment income can be confusing, especially since there are several ways investment income is taxed. An investor may be familiar with capital gains taxes—the taxes imposed when one sells an asset that has grown—but less clear on the implications of dividends, interest and other ways in which investments have tax implications.

 

Certain types of investment vehicles—529 plans, retirement plans like 401(k)s and IRAs—are either not taxed until money is taken out of the account, or may not ever be taxed, depending on the reason and timing for taking money from the account. But general investing accounts come with tax liabilities.

 

Being well aware of all the tax liabilities your investments hold can minimize headaches and help you avoid a surprise bill from the IRS. Working with a professional can be helpful as an investor’s portfolio grows, or as they find themselves selling assets to fund a purchase, like the down payment on a home. But for all investors, it makes sense to familiarize yourself with the different types of taxes on investment income and some potential strategies investors use to limit taxes.

 

Related: What is leverage?

 

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There are several types of taxes on investments. These include:

  • Dividends
  • Capital Gains
  • Interest Income
  • Interest income
  • Net Investment Income Tax (NIIT)

Taking a deeper look at each category can help you assess whether—and what—you may owe.

 

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Dividends are distributions that are sometimes paid to investors who hold a stock or otherwise have an interest in a partnership, trust, S-corp or other entity taxable as a corporation. Dividends are generally paid in cash, out of profits and earnings from a corporation.

 

Some dividends are ordinary dividends, and are taxed at the investor’s income tax rate. Others, called qualified dividends, are typically taxed at a lower capital gains rate (more on that in the next section). Briefly, the distinction between the two is that stocks that are held for a short period of time are typically subject to a higher tax rate, while stocks held for a longer period of time are typically subject to the lower tax rate. For the full details, the IRS offers information on qualified and non-qualified dividends .

 

Generally, an investor should expect to receive form 1099-DIV from the corporation that paid them dividends, if the dividends amounted to more than $10 in a given tax year.

 

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Capital gains are the profit an investor makes between the price of an asset when purchased, versus the price of an asset when sold. Capital gains taxes are the taxes levied on the net gain between purchase price and sell price.

 

There are two types of capital gains taxes: Long-term capital gains and short-term capital gains. Short-term capital gains apply to investments held less than a year, and are taxed as ordinary income; long-term capital gains are held for longer than a year and are taxed at the capital-gains rate (for 2021, the
IRS rates are no higher than 15% for most individuals, $0 if your taxable income is less than $80,0000)

 

The opposite of capital gains are capital losses—when an asset loses value between purchase and sale. Sometimes, investors use losses as a way to offset tax implications of capital gains. Capital losses can also be “carried forward” to future years, which is another strategy that can help lower an overall capital gains tax.

 

Capital gains and capital losses only become taxable once an investor has actually sold an asset. Until you actually trigger a sale, movement in your portfolio is called unrealized gains and losses. Seeing unrealized gains in your portfolio may lead you to question when the right time is to sell, and what tax implications that sale might have. Talking through scenarios with a tax advisor may help spotlight potential avenues to mitigate tax burdens.

 

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Interest income on investments are taxable at an investor’s ordinary income level. This may be money generated as interest in brokerage accounts or interest from assets, such as bonds or mutual funds. The only exception are investments in municipal (muni) bonds, which are exempted from federal taxes and may be exempt from state taxes if they are issued within the state you reside.

 

Interest income (including interest from your bank accounts) is reported on form 1099-INT from the IRS. Tax-exempt accounts, such as a Roth IRA or 529 plan, and tax-deferred accounts, such as a 401(k) or traditional IRA, are not subject to interest taxes.

 

tommaso79 / istockphoto

 

The Net Investment Income Tax (NIIT), now more commonly known as the “Medicare tax”, is a 3.8% flat tax rate on investment income for taxpayers whose adjusted gross income (AGI) is above a certain level—$200,000 for single filers; $250,000 for filers filing jointly. As per the IRS, this tax applies to investment income including, but not limited to: interest, dividends, capital gains, rental and royalty income, non-qualified annuities, and income from businesses involved in trading of financial instruments or commodities.

 

For taxpayers with an AGI above the required thresholds, the tax is paid on the lesser of the taxpayer’s net investment income or the amount the taxpayer’s AGI exceeds the AGI threshold.

 

For example, if a taxpayer makes $150,000 in wages and earns $100,000 in investment income, including income from rental properties, their AGI would be $250,000. This is $50,000 above the threshold, which means they would owe NIIT on $50,000. To calculate the exact amount the taxpayer would owe, one would take 3.8% of $50,000, or $1,900.

 

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One way to mitigate the effects of investment income is to create a set of tax efficient investing strategies. These are strategies that can minimize the tax hit that you may experience from investments and allow you to grow your wealth.

 

These strategies can include:

  • Diversifying investments to include investments in both tax-deferred and tax-exempt accounts. An example of a tax-deferred account is a 401(k); an example of a tax-exempt account is a Roth IRA. Investing in these vehicles may be a strategy for long-term growth as well as a way to ensure that money is earmarked for certain purposes. While these are commonly thought of as retirement vehicles, there are other times when they may be tapped. For example, funds in a Roth can be used for qualified education expenses.
  • Exploring tax-efficient investments. Some examples are municipal bonds, exchange-traded funds (ETFs), treasury bonds, and stocks that do not pay dividends.
  • Considering tax implications of investment decisions. When selling assets, it can be helpful to keep tax in mind. Some investors may choose to work with a tax professional to help offset taxes in the case of major capital gains or to assess different strategies that may have a lower tax hit.

 

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Underreporting or ignoring investment income can lead to tax headaches and may result in a taxpayer underpaying their overall tax bill. That’s why it’s a good idea to keep track of your investment income, and be mindful of any dividends and interest that may need to be reported even if you didn’t sell any assets over the course of the year.

 

Because the tax code can be tricky, with different rules applying to different levels, familiarizing yourself with different types of taxes, analyzing any paperwork or forms you received, and asking questions well before filing can help you make sure you didn’t overlook any potential tax requirements when it comes to your investment portfolio.

 

Some investors may find it helpful to work with a tax professional, who can help them see the full scope of their liabilities and help them become aware of potential investment strategies that could help them minimize their tax burden. A tax advisor will also be aware of any specific state tax rules regarding investment taxes.

 

Learn More:

This article
originally appeared on 
SoFi.comand was
syndicated by
MediaFeed.org.

 

SoFi Invest
The information provided is not meant to provide investment or financial advice. Investment decisions should be based on an individual’s specific financial needs, goals and risk profile. SoFi can’t guarantee future financial performance. Advisory services offered through SoFi Wealth, LLC. SoFi Securities, LLC, member FINRA  SIPC  . SoFi Invest refers to the three investment and trading platforms operated by Social Finance, Inc. and its affiliates (described below). Individual customer accounts may be subject to the terms applicable to one or more of the platforms below.
1) Automated Investing—The Automated Investing platform is owned by SoFi Wealth LLC, an SEC Registered Investment Advisor (“Sofi Wealth“). Brokerage services are provided to SoFi Wealth LLC by SoFi Securities LLC, an affiliated SEC registered broker dealer and member FINRA/SIPC, (“Sofi Securities).
2) Active Investing—The Active Investing platform is owned by SoFi Securities LLC. Clearing and custody of all securities are provided by APEX Clearing Corporation.
3) Cryptocurrency is offered by SoFi Digital Assets, LLC, a FinCEN registered Money Service Business.
For additional disclosures related to the SoFi Invest platforms described above, including state licensure of Sofi Digital Assets, LLC, please visit www.sofi.com/legal. Neither the Investment Advisor Representatives of SoFi Wealth, nor the Registered Representatives of SoFi Securities are compensated for the sale of any product or service sold through any SoFi Invest platform. Information related to lending products contained herein should not be construed as an offer or pre-qualification for any loan product offered by SoFi Lending Corp and/or its affiliates.
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