The beauty of investing in the stock market is that you give your money a chance to work for you. If you buy a stock at one price and it grows in value, you can benefit from capital appreciation. Those are the moments when you tend to shout your victories from the rooftop, but stock market profits aren't guaranteed on every investment.
If you sold stocks in 2022, you may have experienced the other side of the equation: Stock market losses. Although losses don't look pretty in your investment account, they could be a victory on your tax return if you take advantage of tax loss harvesting. Below, we'll break down how it works and the rules you should know.
Breaking down capital gains taxes
There are two situations you need to prepare for in the stock market: making money and losing money.
If you make money in the stock market, you'll be on the hook for capital gains taxes. These taxes apply any time you sell a stock for more than you paid for it. Let's say you buy a stock for $100 and you sell it for $400. You have a $300 capital gain. Your gain would be short-term or long-term, depending on how long you held on to the stock before selling it.
Losses are the other side of the story. Although losses are something you may try to avoid, you need to be aware of what happens if you are ever in that situation. Let's say you buy a stock for $400, and the stock price drops to $100. You won't have a real capital loss until you sell the stock.
The IRS won't require you to pay taxes on losses in the stock market. On top of that, you'll be able to use your losses to offset your gains on your tax return. We'll dive into that next.
Stock market losses aren't the end of the world
Although stock market gains are the ultimate goal, losses aren't always a bad thing. It's possible to turn your stock market loss into tax savings if you use tax loss harvesting.
Here's how it works. Let's say you bought shares of stock for $9,000 and sold them for $4,000 in a taxable brokerage account. You have a $5,000 capital loss. This can offset any capital gains you have -- even gains from other assets like cryptocurrency.
All your short-term losses can offset short-term gains, and your long-term losses can offset long-term gains. If you have a $5,000 long-term capital loss and an $11,000 long-term capital gain, you will be left with a $6,000 capital gain. Now, if you have any short-term losses, it can offset the $6,000 long-term gain. You may be in a position where your losses exceed your gains. You can use up to $3,000 of your remaining losses to offset your ordinary income. This includes income from wages, salaries, dividends, and taxes.
As you can see, tax loss harvesting can lower your tax tab by allowing you to benefit from selling investments at a loss.
Don't forget about the wash sale rule
If you're trying to sell an investment and claim a loss on your tax return, you have to watch out for the wash sale rule.
The IRS won't allow you to buy the same asset or a "substantially identical" one within 30 days before or after you sold at a loss. If you do this, the loss would be disallowed. Before you proceed with tax loss harvesting, make sure you consult with your tax advisor so you don't end up in trouble with the IRS.
Get ready to brag about your losses during tax season
Stock market losses don't always have to bring you down. You can turn your losses into victories on your tax return by using tax loss harvesting. Then, you can carry forward any extra losses to future tax years, and set yourself up for future tax benefits. On top of that, you can invest the proceeds from your sale in other assets that can grow over the long term.
It's important to learn how to leverage the tax code during both the good times and the bad, so you can turn your pain into strategic gains.