Combine all gains and losses – remember at the end of the year, you combine all of your gains and losses. Only if you had more losses than gains would you have a “net loss.” If your total capital loss on your tax return is greater than $3,000 then you are capped at that number and any additional amount is carried forward to subsequent tax year.
Essentially there are four categories for capital transactions: (1) short-term gains, (2) short-term losses, (3) long-term gains, and (4) longer-term losses. Basically, you have four scenarios that can occur:
Long-term gain with short-term gain
The long-term gain gets the preferential rate of 10% to 20%, depending on your tax bracket. The short-term gain is taxed with your other income at your marginal rate.
Long-term loss with short-term gain
We have two scenarios here. (1) If the short-term gain is larger than the long-term loss, you have a net short-term gain — taxed at your ordinary marginal rate. (2) If the long-term loss is bigger, you have a net long-term loss. Up to $3,000 can be used to offset other kinds of income. Any unused amount will carry forward to the following year as a long-term loss.
Long-term gain with short-term loss
Again we have to consider two scenarios. (1) If the long-term gain is bigger than the short-term loss, you have a net long-term gain and get to take advantage of the favorable capital gains rates for the net gain. (2) If the short-term loss is larger, it is a net short-term loss. Just like the previous situation, you can use up to $3,000 of that loss against other types of income, with any balance carrying forward to the next year as a short-term loss.
Long-term loss with short-term loss
If the total of the two losses is less than $3,000, then you can use that loss against other types of income. But what if the total loss is more than $3,000 and some must be carried over to next year? Is the carryover short-term or long-term? It will never be just short-term but could potentially be a combination of the two. This is because you must use the short-term losses first.
If your short-term losses are more than $3,000, you use the first $3,000 to offset ordinary income, then carry the remaining short-term loss along with all of the long-term loss over to next year. If the short-term loss is less than $3,000, you can just total the two losses together, take the $3,000 off, and the balance is a long-term loss carryover to the following year.
So, the process for determining the long-term or short-term character of your capital gains and losses can be summarized in three steps:
Net your long-term items together.
Net your short-term items together.
Determine which of the above four situations applies to you.