DEDUCTING CAPITAL LOSSES

Tom Herman of the ASK DOW JONES blog of the Wall Street Journal recently dealt with the issue of the $3,000 maximum annual capital loss deduction in “There's No Dollar Limit on Capital-Loss Carry-Overs”.

Capital losses can be used to reduce, or wipe out, capital gains.  If you have more losses than gains you can claim a current deduction of up to $3,000 in net losses.  Losses in excess of $3,000 can be carried forward indefinitely until used up.  

Tom quotes an IRS example:

“Suppose a married couple lost $7,000 on the sale of securities last year and had no other transactions. Their taxable income was $26,000. ‘On their joint 2012 return, they can deduct $3,000,’ the IRS said. ‘The unused part of the loss, $4,000 ($7,000−$3,000), can be carried over to 2013.’"

If the couple had no capital gains in 2013 they would deduct $3,000 on their 2013 Form 1040 and carry $1,000 forward to 2014.

When I first started preparing 1040s in 1972 the annual net capital losses deduction was $1,000.  The Tax Reform Act of 1976 increased the maximum annual deduction to $2,000 for 1977 and $3,000 for tax years starting after 1977.  The $3,000 maximum has been in place for 35 years.

For a detailed history of the treatment of capital gains and losses, see “Congressional Research Service, Individual Capital Gains Income: Legislative History”, last updated in May 2006.

What are the chances that the $3,000 limit will be increased as part of the, hopefully, rewrite of the Tax Code this year?  Tom quotes former House Ways and Means tax staffer Tim Hanford, a consultant in Bethesda, MD -

“{The idea of increasing the $3,000 limit} has gotten little attention in Congress" during the past few years.  It is possible that it could be considered as part of the fundamental tax reform the Senate Finance Committee and House Ways and Means Committee are working on.  However, one factor Congress would have to take into account is the cost to the federal government of increasing the loss limit."

Back in 2002 I wrote to Dubya with a tax proposal related to excess capital losses.  I proposed that investors be given the option to "carryback" unused capital losses to be deductible against previous years' net capital gains.

At the time I felt that this option was especially appropriate in the context of the then current economic reality. During the late 1990s and into 2000, when the stock market was flourishing, many taxpayers realized, and were taxed on, large capital gains, including excessive capital gain distributions from mutual funds. In most cases these capital gains were reinvested in the market and in additional mutual fund shares.

In 2001 and 2002 the bear market provided these same investors with substantial capital losses. It seems only fair to me that they be allowed to carry back the losses to apply against the earlier gains of the bull market and get a refund of the taxes paid on these gains.

Back then I had 1040 clients, a married couple, who had $200,000+ in net capital gains, much of it short-term, one year, followed the next calendar year by $200,000+ in losses.  So in reality they did not have any net income.  However the $200,000 was taxed, most at ordinary income rates, when earned, but only $3,000 in losses was deducted per year in subsequent years.  Unless the taxpayers have another huge gain in a subsequent year, it will take forever to fully use up the $200,000+ in net capital losses.  A dozen years later there is still a substantial unused capital loss carryover.

As a point of information - this situation was not uncommon, and is one reason why there was a budget surplus during the Clinton years.

The clients, New Jersey residents, were especially screwed by the State of New Jersey.  NJ does not allow the deduction or carryover of excess capital losses.  So they paid NJ state tax on the $200,000+ in the year earned, and got no tax relief for the $200,000+ in losses the next year.

FYI, I received the following response to my letter to Dubya about 8 months after it was sent –

"Dear Mr. Flach:

On behalf of President Bush, I thank you for your letter. The President appreciates hearing your view and concerns.

President Bust remains confident in the faith and resolve of our Nation, and he is confronting our country's challenges with focus, clarity, and courage. As the President has said, this is a time of great consequence, and he is working for a prosperity that is broadly shared, strengthening domestic programs vital to our country, and answering every danger that threatens the American people.

To accomplish these goals, President Bush welcomes suggestions from all Americans. Thank you again for sharing your ideas.

Sincerely,

Desiree Thompson

Special Assistant to the President and Director of Presidential Correspondence"   

Not as lengthy as the reply I received to a recent 4-page letter to BO on tax reform, and under the signature of a “lackey” and not Dubya himself, but just as non-responsive.

I still believe that my 2002 proposal is a valid one, and should be included in the, again hopefully, upcoming rewrite of the mucking fess that is our Tax Code.  And I believe that the $3,000 maximum deduction should be increased and perhaps indexed for inflation.

What do you think?

TTFN