January 15, 2019
Last month, we discussed the importance of knowing how an asset is taxed when it is sold, and focused on capital gains. This month, we would like to address capital losses, as those too can affect a client’s financial situation – in fact they can be quite beneficial.
First, let’s define what kind of loss has a tax benefit. A capital asset describes any asset that you hold, whether it be for personal or business purposes. This could include, for example, your home, car, stocks, bonds or gold coins. If you sell an asset for less than its adjusted cost basis (see last month’s newsletter for our discussion of cost basis) you will have a loss. The IRS has restrictions on which losses you can deduct from your income. You cannot deduct losses from personal-use assets, such as your personal residence, car or boat. But if you held the asset for investment purposes then you can deduct the loss. Examples of this would include mutual funds (not held in retirement accounts) or a rental home. While no one wants to lose money on an investment, the loss is more palatable when it saves on taxes.
Tax-deductible losses are treated in a specific manner. They are first used to offset any capital gains you have for the same year that the loss is generated. If you still have losses in your pocket after matching them against gains, you can deduct up to $3,000 of them against your ordinary income. Here is a simple example:
Joe bought and sold many stocks this year. He generated gains of $9,000 and losses of $15,000. Joe first offsets his gains and losses, which leaves him with losses of $6,000. Joe then applies $3,000 against his personal income. The losses that are left over, $3,000, are carried over to the following tax year to be applied in the same way.
Because losses are used to offset capital gains and ordinary income they are very helpful in keeping your tax burden down. Therefore, in a divorce it is possible that both parties may want to keep any losses that are unrealized (the asset is not yet sold), as well as any that are generated in the year of the divorce or have been carried forward from past years.
Dividing past losses is not always straightforward, and can be quite complicated. Generally speaking, we look to how the loss was originally generated. If it was generated on a joint asset, it is split. If it is generated on a separately owned asset, it stays with that owner. Let’s look at two scenarios for Rob and Sally to illustrate this concept:
This can get quite complicated when multiple years of realized losses have been carried forward, and an accountant may be needed to untangle the trail of losses. While this is something that will take place post-divorce, its effect on the future tax burden, and cash flow, of your client may be an important consideration in the divorce process.