When you have a taxable investment account, also known as a joint account or individual account, you can realize capital gains or capital losses for a given tax year. How does this happen? Well, if you are selling any of your investment holdings within the account, such as stocks, mutual funds or ETFs for example, then you are going either realize a gain or a loss depending on what your basis is on the position and what you sold it for. More simply, if you sold it for more than it cost you to buy then you will realize a gain and if you sold if for less than what it cost you to buy then you will realize a loss.
A realized gain will be taxed either at capital gains rates or ordinary income rates depending on how long you held the position. Held more than 1 year it is taxed at capital gains rates. Held 1 year or less it is taxed at ordinary income rates.
Now what happens when you have realized losses within your account for a given year?
Did you know that capital losses can actually be a good thing for tax purposes?
Capital losses can be deducted against your ordinary income. Currently, you can deduct $3k of capital losses against your ordinary income in a given tax year, any loss above that can be carried over to subsequent tax years. In subsequent tax years the carryover loss can be deducted against your ordinary income again, at $3k, or can be used to offset any gains you have in those subsequent tax years.
This is nice.
For example, let’s say for 2022 you incurred a net capital loss of $10k. You would be able to deduct $3k against your ordinary income for 2022. You would then have a $7k carryover to 2023. With that $7k carryover you potentially could again deduct $3k against your ordinary income in 2023 and carryover a $4k capital loss to 2024, or you could use the $7k carryover loss from 2022 to offset up to $7k in gains for 2023. This essentially makes the first $7k in gains tax-free for you in 2023.
This makes realized losses in your taxable account a potentially valuable and flexible tool at your disposal for tax planning purposes. I have seen clients from time to time get a little disappointed that they can only deduct $3k of losses against their ordinary income in a given year when they have losses that exceed $3k, but I remind them to not be discouraged and instead be encouraged that if you have a carryover loss to the next tax year it is there to help potentially lower your tax liability by offsetting gains that may have otherwise been taxable to you.
If you want to discuss how realized gains and/or losses may be used for you and your situation, make sure you discuss your situation with your financial advisor and tax advisor.