Because it's impossible to predict the stock market, it's essential to learn the best way to write off losses.
The deck is stacked against you
The tax code disenfranchises investors and traders from deducting losses. The capital-loss limitation, wash-sale loss deferrals, passive-loss activity limitations and carryovers, investment interest expense carryovers, wasted personal investment losses, at-risk limitations and more are used to pay for or offset lower long-term capital gains rates (up to 20%) on positions held over 12 months and on qualifying dividends. Ordinary tax rates rise to 39.6%, almost twice as high as long-term capital gains rates.
Buy and hold investments
If you buy and hold securities, you may wind up selling and holding capital loss carryovers. If you have unrealized capital gain positions and are close to the 12-month holding period for lower long-term capital gains rates, consider buying protection on the long equity position in the options market (e.g., buying a put option).
Capital-loss carryovers can take decades to use up
Many investors still haven't used up their capital-loss carryovers realized in the dot.com crash in 2000. While capital losses are deductible in full against capital gains, individuals may only deduct $3,000 of capital losses per tax year against non-capital gains income like wages. Plus, that $3,000 limitation isn't indexed for inflation. I've seen it take decades to use up capital-loss carryovers in the hundreds of thousands of dollars for many clients.
Pundits suggest planning for losses at this time
Since the Great Recession and market meltdown of 2007, the financial markets recovered to new highs riding the coattails of Fed monetary easing and government stimulus which appear to be ending soon. The world's locomotive economy China is apparently slowing and its financial markets are exhibiting some signs of boom/bust conditions. That seems to be causing contagion in emerging and even developed markets.
While some investors see buying opportunities, others feel it's different this time around and they don't want to catch a falling knife.
Five ways to maximize losses on tax returns
1. Elect Section 475 for unlimited ordinary losses
If you trade as a business activity and qualify for trader tax status (TTS), you're entitled to make a timely Section 475 MTM election. Section 475 trades are reported on Form 4797 (Sale or Business Property) Part II ordinary gain or loss tax treatment. Ordinary losses are exempt from capital-loss limitations and wash-sale loss deferral rules.
Unfortunately, too many traders and tax advisors aren't experienced with Section 475 and TTS and they missed filing a 2015 election by April 15, 2015 for existing individuals and partnerships and March 15 for existing S-Corps.
"New taxpayers" (new entities) can elect Section 475 within 75 days of inception, so consider a new entity later in the year. Caution: pre-entity losses remain capital losses, so wait the 75 days to decide whether to elect 475 internally or not. If the entity has capital gains, it can pass through capital gains to soak up individual-level capital losses, so you can skip the entity 475 election that first year. Conversely, if the entity has significant losses, you should elect Section 475 for ordinary loss treatment. You can revoke Section 475 the following year to get back to generating capital gains to soak up capital-loss carryovers. If you dig a big hole of capital-loss carryovers, it's important to climb out of that hole with a capital gains ladder and not dig a bigger hole with a Section 475 floor.
2. Net operating losses generate tax refunds
Section 475 ordinary losses reduce gross income without any limitation. If you have negative taxable income, Section 475 losses are includible in a net operating loss (NOL) tax computation. NOLs are carried back two tax years and or forward 20 years. You can file a timely election to forgo the NOL carry back and only carry it forward. NOLs offset all types of income.
3. Wash sale losses require careful management
If you take a loss on a security in a taxable account and buy a substantially identical position back 30 days before or afterward in any of your individual accounts including IRAs, it's considered a wash-sale loss. On taxable accounts, it's a deferral with adding the wash-sale loss adjustment to the replacement position's cost-basis.
Caution: The wash-sale loss is permanently lost on an IRA account. That rule does not apply to qualified retirement plans like a Solo 401(k). Lesson: don't trade substantially identical positions between taxable and IRA accounts. Also, consider active trading in an entity account — this account is considered a different taxpayer, although related party rules can apply if you purposely try to avoid wash sales with the related accounts.
Monitor wash-sale loss conditions using software like Tradelog and "break the chain" on wash sales at year-end. (Don't worry too much about wash sale losses on taxable accounts during the year as they may melt away by year-end and that's when it counts most.) Break the chain means realize the loss and don't buy back a substantially identical position 30 days before or afterward. "Substantially identical position" means between Apple stock and Apple options and Apple options at different expiration dates. Apple stock and Google stock are not substantially identical positions.
Note that broker-issued 1099Bs calculate wash-sale loss adjustments on a per account basis and based on identical positions. Broker rules differ from taxpayer rules who calculate wash sales based on all their accounts including IRAs based on substantially identical positions. This causes non-compliance and significant confusion.
4. Section 1256 loss carry back election
In general, capital losses may never be carried back like NOLs. There is one exception: Section 1256 contract losses may be carried back three tax years but applied only against Section 1256 gains in those prior years.
Section 1256 contracts include regulated futures contracts (RFCs), broad-based indexes like e-minis, options on futures, options on indexes and non-equity options. A broad-based index has 10 or more underlining securities in the index (e.g. S&P 500). Exchange-traded funds (ETFs) are securities and they aren't Section 1256 contracts.
Section 1256 contracts have other tax breaks. Section 1256 contracts are marked-to-market (MTM) which means wash-sale loss rules are a moot point and don't apply. MTM also means a long-term holding period of 12 months is impossible to achieve so Congress negotiated a blended long-term and short-term capital gains rate: 60% and 40%, respectively. In the highest tax bracket, the blended 60/40 rate is 28%, almost 12% less than the highest ordinary rate (39.6%). There are meaningful differences in the rates throughout the tax brackets since the lowest long-term rate is 0% for the 10% and 15% ordinary tax brackets.
Unlike a Section 475 election required during the tax year, a Section 1256 loss carry back election can be made after year-end. Simply check the box on top of Form 6781 for the Section 1256 loss carry back election. Omit the losses from the current year tax return and include them on amended tax returns for one or more of the prior three tax years (in order of oldest year first).
5. Forex losses are ordinary by default
Spot forex trading losses in the Interbank market are Section 988 ordinary gain or loss treatment, meaning they aren't subject to the capital-loss limitation or wash-sale loss treatment.
Unlike manufacturers, investors and traders holding forex as a capital asset may file a contemporaneous and internal capital gains election to opt out of Section 988 into capital gain or loss treatment. If you have large capital-loss carryovers, that election can help soak up losses with capital gains on forex trading.
Caution: If you have negative taxable income caused by forex trading losses, you need trader tax status to have NOL treatment. Otherwise, you'll waste part or all of your forex loss since it's not a capital loss carryover.
If you trade the major currencies, with the capital gains election you can navigate into lower Section 1256(g) 60/40 tax rates and use the Section 1256 loss carry back election. Section 988 losses over $50,000 require a Form 8886 filing.
Losses in retirement plans
In traditional retirements plans, taxes are deferred on trading gains until taxable distributions are withdrawn in retirement. Losses are deferred deductions because they reduce retirement distributions accordingly.
It's different with Roth IRA and Roth Solo 401(k) plans. There are no taxes owed on normal retirement distributions with permanent deferral. That means losses are not deductible and they are wasted. If you lose a lot in a Roth conversion executed for 2014 or 2015, you may be able to reverse the Roth conversion in order to benefit from the losses.
Losses can paralyze investors. Some exit the markets entirely, figuring they can't afford more non-deductible capital losses. Traders need refunds from losses to replenish their trading capital. Understand what you are trading and how losses work and maximize your tax affairs accordingly. Consult with a trader tax expert.
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