Section 12.3: Capital Losses, Carry-Forwards, & Wash Sales

  • Offsetting Capital Gains with Capital Losses

  • Using Excess Losses to Reduce Ordinary Income

  • Carry-Forward Losses

  • Wash Sales

Offsetting Capital Gains with Capital Losses:

  • Capital losses may be used to offset capital gains on a dollar-for-dollar basis.

  1. Example:
    If you have $10,000 in capital gains and $7,000 in capital losses,
    then:

    10,000 − 7,000= 3,000 net capital gain

    ✅ You only pay taxes on $3,000 of gains.

Using Excess Losses to Reduce Ordinary Income:

  • If your losses exceed your gains, you can use up to $3,000 of those extra losses to reduce ordinary income for that year.

  • This helps lower your taxable income.

  1. Example:
    Capital gains = $24,000
    Capital losses = $32,000

    32,000 − 24,000 = 8,000 net loss

    You can:

    • Use $3,000 of that loss to reduce ordinary income this year.

    • Carry forward the remaining $5,000 to future years.

Carry-Forward Losses:

  • Unused capital losses (beyond the $3,000 limit) may be carried forward indefinitely.

  • There is no time limit on how long you can use them.

  • These are called carry-forward losses.

  1. ✅ You can continue using them year after year until fully used.

Wash Sales:

  • A wash sale occurs when an investor sells a security at a loss and then repurchases the same or substantially identical security within 30 days before or after the sale.

Key details:

  • The loss cannot be used for tax purposes if the sale is a wash sale.

  • The rule applies to both:

    • Long positions

    • Short positions

  • Applies to:

    • The same security

    • Substantially identical securities (like options or convertibles)

⚠️ A wash sale is not illegal, but claiming the loss on taxes is.

Gains & Losses

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Gains & Losses 〰️

Wash Sale Example 1:

  • Timeline:

    • Oct 21, 2015: Buy 1,000 shares of XYZ @ $30

    • Nov 17, 2016: Sell 1,000 shares of XYZ @ $28 → establishes a $2,000 loss

    • Nov 23, 2016: Buy 1,000 shares of XYZ @ $27

    Since the repurchase occurred within 30 days, the IRS classifies this as a wash sale.
    🚫 The $2,000 loss cannot be used for tax deduction.

Wash Sale Example 2 (Substantially Identical Securities):

  • Scenario:

    • Customer sells 500 shares of XYZ common stock at a loss.

    • Three days later, buys 3 XYZ call options (each = 100 shares).

    Because call options give the right to buy the same stock, they are considered substantially identical to the stock itself.

    ✅ The wash sale applies to the 300 shares represented by the 3 call options.
    ✅ The investor can still claim losses on the remaining 200 shares (not repurchased).

Summary Chart

Rule / Key Point / Tax Impact

  • Capital Loss Offset / Losses offset gains $1 for $1 / Reduces capital gains tax

  • Excess Loss Deduction / Up to $3,000 of excess losses reduce ordinary income / Reduces income tax

  • Carry-Forward Losses / Unused losses carried forward indefinitely / Future tax benefit

  • Wash Sale Rule / Rebuy same or substantially identical security within 30 days / Loss disallowed

  • Substantially Identical / Options or convertibles tied to same stock / Treated as same security

✺ Review questions ✺

  • They can offset capital gains dollar-for-dollar.

  • Up to $3,000 per year may offset ordinary income.

  • Unused losses are carried forward indefinitely until used.

  • Selling a security at a loss and repurchasing the same or substantially identical one within 30 days before or after the sale.

  • The wash sale window is 30 days before or after the loss sale date.

  • The wash sale itself is not illegal, but using the disallowed loss for tax purposes is.

  • A security that is essentially the same, such as an option or convertible that can be turned into the same stock.

  • The 300 shares covered by the call options are disallowed; the 200 remaining shares’ loss can still be used.