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Offsetting gains with losses
Capital gains and capital losses represent the profits and losses you earn on your investments when you sell them.
(Note: If you own shares of a mutual fund, the fund will more than likely distribute capital gains to you even if you did not sell any shares. You are required to declare this income as capital gains.)
If your capital losses exceed your capital gains, you may offset all of your capital gains and up to $3,000 of ordinary income. (If you are married and filing a separate tax return, the limit on offsetting ordinary income is $1,500.)
Capital losses that exceed the sum of your capital gains and $3,000 of ordinary income may be carried over to next year to offset additional capital gains and ordinary income.
Let's look at an example. For 2005, let's say you had capital gains of $1,000 and capital losses of $6,000. (Ouch.) Since you may offset all of your entire capital gains as well as $3,000 of ordinary income, you use $4,000 of your capital losses for 2005 and carry over $2,000 to 2006.
If you have no capital gains for 2006, you may still offset up to $3,000 of ordinary income. If you incur more capital losses in 2006, you may add these losses to your $2,000 in capital losses. You may offset another $3,000 of ordinary income and carry over the unused balance of capital losses to use in 2007.
Long-term capital gains or losses are earned on capital assets held for longer than one year. Short-term capital gains or losses are incurred on assets held for one year or less. As a result, when you calculate your capital gains and losses, you will have net amounts for long- and short-term assets.
Keep in mind that long-term capital gains are eligible for a lower tax rate but short-term capital gains are taxed as ordinary income (no preferential rate). As a result, long-term gains are more valuable since they cut your tax bill by more. When you offset capital gains with losses, you must first offset any long-term capital gains with long-term capital losses before offsetting short-term capital gains.
For example, let's assume you have $1,000 in both long- and short-term capital gains. You also have $1,500 in long-term capital losses. You must first offset the entire amount of long-term gains before offsetting the $500 of short-term gains.
To help you calculate your capital loss carryover amount, see the worksheet in the instructions for Schedule D of IRS Form 1040.
(Note: These documents are in Portable Document Format (PDF). If you do not have a PDF reader installed on your computer, you can download a version of Acrobat Reader for free at Adobe Systems' Web site.)
Next, we explain how to benefit from using tax-advantaged accounts for investing.
This information should not be interpreted as financial advice. For advice that is specific to your circumstances, you should consult a financial or tax adviser.
Next Topic: Tax-advantaged accounts
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