Business losses, to the extent they are active, can offset capital gains. Capital gains arise from selling capital assets like stocks, bonds, real estate, or mutual funds at a profit. Being able to offset these gains with business losses offers a great opportunity for tax savings.
There are several ways to use business losses (including ordinary losses, net operating losses, and capital losses) to offset capital gains dollar for dollar and minimize your tax liability. An expert CPA can guide you through the options and help you maximize your savings.
Offsetting Capital Gains With Business Losses
All capital gains can be offset by business losses as long as the losses are from an active trade or business. There are three kinds of losses you can declare:
- Ordinary losses
- A net operating loss (NOL)
- Capital losses
Using an Ordinary Loss to Offset Capital Gains
An ordinary loss occurs when you make less from the sale of a (ordinary) good or service than it cost you to provide or produce it. You can use ordinary losses to offset any kind of income in the same tax period, dollar for dollar. However, any excess can’t be carried forward to future tax years.
Using a Net Operating Loss (NOL) to Offset Capital Gains
A net operating loss (NOL) occurs when your business’s allowable deductions are greater than your taxable income for the year. If you’re a sole proprietor or own a pass-through entity like an LLC, S corporation, or partnership, you may qualify to deduct net operating loss (NOL) against your other sources of income, including wages, interest, dividends, and capital gains. However, before doing so, you’ll need to pass the IRS’s at-risk and passive activity tests.
Note: If you actively operate multiple businesses, you can only report an NOL if the combined losses from all your businesses exceed their total income.
Excess Business Loss Rule
Under the IRS’s excess business loss rules, you can deduct up to $262,000 ($524,000 for joint filers) of business losses against nonbusiness income per tax year.
Carryforward Rule
Any net operating losses exceeding the excess business loss threshold can be carried forward to future tax years. NOLs can be used to offset future income (including capital gains) and reduce taxes in profitable years. They can be carried forward indefinitely but only used to offset up to 80% of your taxable income in any given year.
For example, a sole proprietor incurs a $150,000 loss in 2022 and reports no taxable income. In 2023, she generates $80,000 in profit and uses the prior year’s loss to deduct $64,000 (80%), leaving $86,000 to offset future income.
Consulting with professional tax planning services is crucial for effective tax planning and compliance with carryforward rules, especially if your business anticipates a loss in the current fiscal year.
Caveats to this Rule
There are a couple of caveats to keep in mind when using business losses to offset capital gains.
Active vs Passive Income
You can only use business losses to offset capital gains if the business is active in nature. If the business activity is passive in nature then the losses would not offset capital gains. Passive losses can only offset passive profits.
Personal vs Business Income
Losses from a pass-through business can be used to offset either business or personal capital gains because business income and personal income are considered one and the same on the business owner’s individual tax return.
Losses from a C corp have no bearing on a person’s individual capital gains and cannot be used to offset them. C corp losses, however, can be used to offset capital gains from the C corp.
State-Level Variations in Business Loss Deduction Rules
While federal tax rules allow for carrying forward net operating losses indefinitely at 80% of your taxable income, state regulations differ. Twenty-seven states impose their own provisions for NOL treatment. It’s important to understand your specific state’s tax rules, as they may restrict or alter how business losses are deducted at the state level.
Consulting with a state-specific tax professional ensures compliance with local regulations and helps you maximize your deductions.
Offsetting Capital Gains With Capital Losses
Capital gains can also be offset with capital losses. Capital losses occur when you sell an asset for less than what was paid to purchase it. Capital gains and capital losses are divided into:
- Short-term capital gains/losses: These occur when selling a capital asset held for one year or less. Short-term capital gains are taxed at ordinary income tax rates.
- Long-term capital gains/losses: These apply to assets held for more than a year. Long-term capital gains generally benefit from lower tax rates.
Tip: You will find the current federal short-term and long-term capital gains tax rates in our article, “Florida Short-Term Capital Gains Tax Explained.”
Short-Term Capital Gains vs Long-Term Capital Gains
Capital losses first offset gains of the same type—short-term losses offset short-term gains, and long-term losses offset long-term gains. If your losses exceed gains in one category, you can apply them to the other.
Example
In one year, you had $7,000 in short-term capital losses and $5,000 in short-term capital gains. The losses first offset the gains and leave you with $2,000 in short-term losses.
You also had $4,000 in long-term capital gains. The remaining $2,000 short-term loss is used to reduce your long-term gains. This results in net capital gains of $2,000.
Deducting Excess Capital Losses
If capital losses exceed gains, you can deduct up to $3,000 ($1,500 for married filing separately) against other income, such as wages or interest income.
Capital Loss Carry Forward
Any remaining losses after deducting the excess capital loss can be carried forward to future tax years, reducing your future tax liability. This is particularly useful if you have large investment losses but anticipate significant gains in the future.
Other Ways to Reduce Your Tax Liability With Capital Losses
The following are a few additional strategies to reduce taxes through capital losses.
Tax Loss Harvesting Strategy
You can generate capital losses to offset capital gains by strategically selling investments that have lost value on the original purchase price. This is especially beneficial if you have significant short-term gains, which are taxed at a higher rate.
IRS’s Wash Sale Rule
However, be aware of the IRS wash sale rule! This rule prevents taxpayers from claiming a loss on the sale of a security if they repurchase the same or substantially identical security within a 30-day window before or after the sale. A wash sale is disallowed for tax purposes and is instead added to the cost basis of the repurchased security.
Deferring Capital Gains
If you expect your business to generate significant loss deductions in future years, consider deferring the realization of capital gains until those losses can be used effectively. Timing the realization of gains to coincide with periods of lower taxable income can reduce your overall tax bill.
Utilizing Retirement Accounts
Consider holding capital assets in a tax-deferred account like an IRA or 401(k). Since these accounts are sheltered from capital gains taxes, you can defer the taxation on investment growth until withdrawals are made, typically at retirement when you may be in a lower tax bracket.
Maximize Tax Efficiency With Strategic Planning
There are several ways to offset capital gains with business losses and lower your overall tax liability. These include deducting ordinary losses, net operating losses, and capital losses from your taxable income (including capital gains).
Excess NOLs and capital losses that can’t be claimed fully in the current tax year can be carried forward to future tax years. Ordinary losses can only be deducted in the tax year in which they occurred.
Effective planning around when to recognize gains and losses, along with utilizing carryforward provisions, can lead to long-term tax savings. Consult a CPA to ensure you maximize the available strategies while staying compliant with tax regulations.
