Capital Loss Carryovers

There are many misconceptions about capital-loss carryovers.

Many traders mistakenly think they can only utilize $3,000 of capital-loss carryovers each year going forward, so they worry it can take a lifetime to use up these losses. They don’t realize capital losses are offset without limitation against subsequent-year capital gains, which means if they remain in capital gains treatment (rather than electing Section 475 MTM ordinary income), they can use these capital losses. The $3,000 limitation is against non-capital gains income, not capital gains.

Here’s an example: If a taxpayer’s capital-loss carryover is $50,000 and his subsequent year capital gains are $60,000, he can apply the $50,000 capital-loss carryover in full on Schedule D; his net capital gain would be $10,000. Conversely, if the subsequent year capital gain is $35,000, the net capital loss before limitation would be $15,000. Up to $3,000 is allowed against other income, and the remaining capital-loss carryover to the following year would be $12,000.

Some traders mistakenly think individually generated capital-loss carryovers incurred before trading in a new pass-through entity will be lost. The new entity can forgo a Section 475 election and pass through capital gains on a Schedule K-1 to individual tax returns (Schedule D), where they are offset by individual capital-loss carryovers. This is the best way to climb out of a capital-loss carryover hole. If the entity has capital gains before the 475-election internal resolution is due (within 75 days of entity inception), skip it to soak up capital-loss carryovers. Conversely, if the entity has losses in those first 75 days, elect Section 475 for ordinary loss treatment. The entity can then revoke Section 475 in the subsequent year to get back to capital gains treatment to soak up capital-loss carryovers.

Using up capital-loss carryovers is a critical challenge for many traders. Proper Section 475 MTM election planning and entities are the answer. It pays to think out the nuances carefully and not make a blanket decision to skip Section 475 as that can cost a taxpayer big time!

Excerpt from Green’s 2019 Trader Tax Guide