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Capital Loss: Understanding the Basics

When it comes to investments, there are two types of potential outcomes: capital gains and capital losses. While capital gains refer to the profit made from selling an asset for more than its purchase price, capital losses occur when an asset is sold for less than its purchase price. In this article, we’ll take a closer look at capital losses and how they can impact your investments and taxes.

Definitions

• Realized Capital Loss:

  A realized capital loss occurs when an investor sells a security or property for less than the purchase price. The loss is “realized” because it has occurred and can be calculated by subtracting the sale price from the purchase price. For example, if an investor buys stock for $1000 and then sells it for $800, the realized capital loss would be $200.

  Realized capital losses can be used to offset realized capital gains, which occur when an asset is sold for more than the purchase price. For example, if an investor has $1000 of realized capital gains and $1000 of realized capital losses, the two cancel each other out and the investor would have no net capital gains or losses for tax purposes.

  Capital losses can only be used to offset capital gains in the same year or in the next year, any unused losses can be carried forward indefinitely to offset against future capital gains.

  It’s important to note that capital losses can only be used to offset capital gains and not against ordinary income.

  Capital losses can also be used to offset up to $3,000 of ordinary income each year. If the capital losses exceed $3,000, the excess can be carried forward to future years to offset capital gains and ordinary income.

  In addition, there are certain restrictions on the deductibility of capital losses. For example, capital losses from the sale of a personal residence are not deductible.

  It’s also important to note that capital losses can only be claimed by the person who realized them. If an investor sells a security or property to another person, the new owner cannot claim the capital loss.

  In summary, realized capital losses occur when an investor sells a security or property for less than the purchase price. These losses can be used to offset capital gains in the same year or in the next year, and any unused losses can be carried forward indefinitely to offset against future capital gains. Capital losses can also be used to offset up to $3,000 of ordinary income each year, but there are certain restrictions on the deductibility of capital losses.

• Unrealized Capital Loss:

  An unrealized capital loss occurs when an individual or entity holds an asset (such as a stock, bond, or real estate) that has decreased in value from the purchase price, but the asset has not been sold. This means that the loss has not yet been realized, as the asset has not been disposed of and the loss has not been recognized for tax purposes.

  For example, if an individual purchases a stock for $100 and the stock subsequently drops to $50, the individual has an unrealized capital loss of $50. However, if the individual continues to hold the stock and the stock price goes back up to $100 or more, the unrealized loss is no longer present.

  Unrealized capital losses can be beneficial for tax purposes as they can offset realized capital gains from other investments, thereby reducing the overall tax liability. For example, if an individual has $10,000 in realized capital gains and $10,000 in unrealized capital losses, the individual would have no net capital gains and would not owe any capital gains tax.

  However, it’s important to note that there are limits on how much capital losses can offset capital gains in a given tax year. For example, in the US, individuals are limited to a maximum of $3,000 in capital losses each tax year, and any excess losses can be carried forward to offset gains in future years.

  Unrealized capital losses can also be used to reduce ordinary income, but again there are limits on how much losses can offset income. In the US for example, the limit is $3000 annually

  It is important to note that unrealized capital losses do not have any immediate financial impact and do not affect cash flow. They are simply a paper loss until the asset is sold. Investors should not make investment decisions based solely on unrealized losses, but should consider their overall investment strategy and risk tolerance.

Examples

1. Let’s say you purchase 100 shares of XYZ stock for $50 per share, for a total cost of $5,000. If the stock’s value decreases to $40 per share and you sell all 100 shares, you would have a realized capital loss of $1,000 ($5,000 purchase price – $4,000 sale price).
2. Imagine you purchased a piece of property for $200,000 and later sell it for $150,000. The difference of $50,000 is your realized capital loss.
3. You bought a painting for $5,000 and later found out it was a fake, so you sold it for $2,000. You would have a realized capital loss of $3,000.
4. A person bought a bond for $10,000 and later the bond value dropped and he sold it for $9,000. This person would have a realized capital loss of $1,000.
5. An individual invested $50,000 in a mutual fund, but the value of the fund drops to $40,000 before the individual sells the shares. The individual would have an unrealized capital loss of $10,000.

Quiz

1. What is a capital loss?
2. What is a realized capital loss?
3. What is an unrealized capital loss?
4. Can an unrealized capital loss be used to offset capital gains or lower an investor’s overall tax liability?
5. What is the difference between a capital gain and a capital loss?
6. In the example provided, if an individual invested $50,000 in a mutual fund, but the value of the fund drops to $40,000 before the individual sells the shares. What is the unrealized capital loss?
7. If an investor purchased a stock for $50 per share and later sold it for $40 per share, what would be the realized capital loss?
8. In the example provided, if a person bought a bond for $10,000 and later the bond value dropped and he sold it for $9,000. What would be the realized capital loss?
9. Can a capital loss be used to offset a capital gain?
10. In the example provided, if you purchased a piece of property for $200,000 and later sell it for $150,000. What would be the realized capital loss?