Knowing the difference between short-term and long-term losses can help you optimize your investment strategy and tax management.
Definition and Examples of Short-Term Losses
A short-term loss typically occurs when you sell an asset you’ve held for one year or less at a lower price than you paid. The IRS classifies asset gains and losses because, at tax time, a sale’s classification determines the type of taxes you may have to pay. A short-term loss is simple to demonstrate. For example, assume you bought $10,000 worth of stock in January. In October of that same year, you sold the stock when it was valued at $6,000. You took a $4,000 short-term loss if there were no other factors influencing its value.
How Short-Term Losses Work
If you own an asset for less than one year and sell it for less than the total amount you paid, you’ve lost money. Whether it is a short-term loss, long-term loss, or not claimable as a loss is determined by the IRS. You’ll first need to figure out the asset’s adjusted basis before deciding you’ve taken a short-term loss.
Adjusted Basis
Your asset has to be valued appropriately when you’re figuring out whether you’ve taken a loss. When you’ve sold the asset, the IRS requires that you calculate its adjusted basis, then determine the difference between the adjusted basis and the sale price. If the sale price is less than the adjusted basis, then you have taken a capital loss. The IRS defines the basis for most assets as the price you paid plus any other additional costs such as commissions or fees. Stocks and bonds you were given have different basis treatments, such as accounting for appreciation, their fair market value on the date you were given them, or the previous owner’s basis. Additionally, some assets held for less than a year could end up counting as long-term capital gains or losses. For example, inherited stock would automatically be considered long-term, regardless of how long the inheritor holds the assets.
What It Means for Individual Investors
When a sale counts as a short-term loss, the IRS allows you to use your capital losses to offset your short-term capital gains by an equivalent amount to reduce your total tax liability. For instance, suppose you had $10,000 in long-term gains for the year, and $10,000 in short-term gains. During that same tax year, you also decided to sell stock you’ve held for years at $10,000 less than your initial investment and adjusted basis, making it a long-term loss. You would then need to subtract that long-term loss from the $10,000 in long-term gains, which would bring your long-term gains to zero. But you would still owe taxes based on $10,000 in short-term gains; those are taxed at ordinary income rates, which are generally much higher than the 15% rate used in many cases for long-term gains. However, if in this same scenario you instead decided to sell stock you’ve only held for a few months at a $10,000 loss, you could bring your short-term gains to zero. So instead of paying ordinary income tax rates on the $10,000 in short-term gains, you could instead pay long-term capital gains rates on your $10,000 worth of long-term gains. After offsetting short-term capital gains, if you still have a higher amount in short-term losses, you can then use them to offset any long-term capital gains.
