Can I Use Capital Losses as Tax Shelters?

Capital losses realized when selling securities for less than you paid can be used to reduce income received from dividend-paying stocks — but only up to a point. The IRS will let you use up to $3,000 in net capital losses to offset income from dividends. Within this limit, you also can use capital losses to shelter other income, such as wages and salaries. Have a conversation with a financial advisor before making investing decisions.

Capital Losses as Tax Shelters

If you buy a stock and sell it for less than you paid, you still may be able to get some benefit from the money-losing transaction by lowering your tax bill. You can often do this by subtracting the resulting capital loss from profits you made on selling other stocks for more than you paid.

The practice of selling securities that have lost value in order to create losses that will shelter other income is called tax-loss harvesting. Tax-loss harvesting is a common practice among investors and can help increase the overall yield from a portfolio.

Capital losses from tax-loss harvesting can do more than shelter gains garnered during the current tax year. These losses often can be carried forward to a future year to protect capital gains from income taxes.

However, tax-loss harvesting can’t be used in quite the same way to reduce taxes on income earned by dividend-paying stocks. That’s because the IRS puts a limit on the amount of capital losses that can be used to shelter dividend income.

Specifically, you can use only up to $3,000 per year of capital losses to offset non-capital gains. This $3,000 limit applies to dividend income as well as ordinary income, such as wages and salaries.

Sheltering Dividend Income with Capital Losses

Dividend income and profits from selling securities you have held for more than a year may both be taxed similarly, using the long-term capital gains tax rate. The two types of income are not treated identically by the tax code in all respects, however.

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One difference is that, when it comes to capital gains from selling securities as a profit, the long-term capital gains rate only applies to securities held for more than a year. The long-term capital gains rate ranges from 0% to 20% and is usually lower than a taxpayer’s regular marginal federal income tax. Gains on securities held less than a year are taxed at the taxpayer’s regular rate, which for 2022 can be from 10% to a maximum of 37%.

Dividend income is taxed at different rates depending on whether the dividends are qualified or non-qualified. Qualified dividends are taxed as capital gains, while non-qualified gains are taxed as ordinary income.

To be qualified, dividends must be received from shares owned for more than 60 days during the 121-day period before 60 days prior to the ex-dividend date. Otherwise, the dividends are non-qualified and taxed at ordinary income rates.

Both forms of dividends can be sheltered by capital losses, subject to the $3,000 limit. Because the tax rates on non-qualified dividends are generally higher, the economic benefit to the investor may be greater when capital losses are used to shelter non-qualified dividends.

Wash Sales

Any time you are engaged in tax-loss harvesting you need to be aware of the wash sale rules. These tax rules prohibit selling a security, recording a loss and then quickly buying the same or a similar security.

If you sell a security at a loss and within 30 days buy the identical or a substantially identical security, the IRS will not allow you to use the loss to reduce taxable income. To avoid this, an investor must wait 30 days to repurchase the security or purchase one that is not substantially identical.

The Bottom Line

The IRS allows you to apply up to $3,000 in net capital gains losses to reduce other taxable income. This lets you potentially save money on taxes. The net capital losses can be applied to ordinary income as well as dividend income. Otherwise, however, capital losses can’t be used to shelter dividend income from taxes.

Investing Tips

• A financial advisor can help you with all your tax-loss harvesting questions. Finding a qualified financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three financial advisors who serve your area, and you can interview your advisor matches at no cost to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.

• Income taxes are only levied on realized capital gains. The way you realize a capital gain is by selling the appreciated security. If there’s no sale, there’s no gain and no taxes. The same goes for tax losses. Unless and until you sell a security for less than you paid, you haven’t realized the loss and can’t use it to shelter other income. This means that at the end of a tax year, investors are often actively selling money-losing investments in order to record the loss for tax-loss harvesting purposes.

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