Every investor wants to see his or her investments make money. However, in some cases, it is best to throw in the towel and accept a capital loss. Such decisions may be based on assumptions of what will probably happen or on knowledge of what will happen. Some of these issues are related to taxes, while others are related to other factors. The following is a guide on when it might make sense to take a capital loss on your underperforming investments.
Let us assume, hypothetically, that an investor bought a stock at $10, and that it is now worth $9.90. Let us also assume that the market indicators suggest that this downward trend was not a mere hiccup: it will continue to go down in value, and it will not reach $10 for some time. In this case, if you strongly believe that the stock price will not recover, you might want to consider selling the stock at a loss. A small loss is always better than a large loss. Keep in mind that there is always the possibility that the stock’s price will increase unexpectedly.
The Sunk Cost Fallacy
When gamblers go to Las Vegas and lose their entire life savings, they usually do not do so because of one mistake. Rather, they do so by repeatedly making the classic sunk cost fallacy. Having already lost some, they feel the need to win back what they have lost, and so they continue on a downward course with the assumption that their fortunes will change. However, having lost money in a venture that shows little sign of turning around, getting out is often the best thing to do. Admit defeat and live to fight another day.
Investments that take a sudden downturn often bounce back eventually. This is especially true for real estate and the stocks of established companies. However, even if that reversal occurs, it may take too long to come. By waiting for it, an investor may be passing up on a number of very lucrative opportunities. If you can take a small loss by liquidating your assets and then reinvest them into something that almost immediately recovers that loss, you might want to consider taking the capital loss.
The Internal Revenue Service allows investors to count most investment losses as tax deductions. For example, if an investor sells an investment for $100,000 when she initially paid $120,000 for it, she may deduct $20,000 from her taxable income when she files her taxes. Even if the investment stands to make a small profit in the near future, it may not be advantageous for her to hold on because that small profit may not offset the potential tax break. The deductions that come in such situations do not count against taxes on normal wages, but against taxes on capital gains. This is important because wages and capital gains have separate tax schedules and brackets.
Items For Personal Use
The tax deduction that the IRS allows for investment only applies to investment vehicles. It does not apply to items purchased primarily for personal use. For example, if an investor purchases real estate as an investment property and then sells it for less than what he bought it for, this is a capital loss that he may deduct from his taxable income. However, if he purchases expensive jewelry for personal use and then sells that at a loss, the loss he takes in that case does not qualify for a tax deduction. When one purchases a home for use as a primary residence, this is a personal-use property. Because the IRS allows tax breaks for capital gains on the sale of a primary residence, some people may assume that it allows capital losses on the sale of a primary residence to count as deductions. However, this is not the case. Capital losses from the sale of a primary residence are treated the same as capital losses from the sale of other personal-use items.
Even when capital losses do qualify for deductions, the IRS limits the total amount an individual may deduct in a particular year. Investors may deduct total capital losses from capital gains until they have $0 in taxable capital gains. After this point, according to the IRS, “you can deduct the excess on your tax return to reduce other income, such as wages, up to an annual limit of $3,000, or $1,500 if you are married filing separately.” Once an investor reaches this limit, she may carry over any additional deduction for capital losses to the next year.
Keep this information in mind if you are thinking about taking capital losses on your investments this tax season. If you are unsure about whether you should take capital losses, it's always a good to touch base with a financial planner or tax expert.