No one likes to lose money when they invest, but the capital loss deduction at least gives you a chance to get a tax break from a bad investment decision. As long as you follow the correct steps and steer clear of some potential pitfalls, then you can use the capital loss deduction to produce valuable tax savings on your return.

The basics of the capital loss deduction

The capital loss deduction lets you claim losses on investments on your tax return, using them to offset income. You calculate and claim the capital loss deduction by using Schedule D of your Form 1040 tax return as part of your required reporting of sales of investments throughout the year.

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How much you're allowed to deduct depends on what kind of income you have. If you have sold other investments at a profit during the year and therefore have capital gains income, then you can use an unlimited amount of capital losses to offset the gains. For instance, if you have capital gains of $12,000 and capital losses of $11,000, then you can use all of the losses to reduce the amount of gains you have to report, leaving you with a net gain of $1,000.

If you have more capital losses than you have gains for a given year, then you can claim up to $3,000 of those losses and deduct them against other types of income, such as wage or salary income. If you have still more capital losses than that, then you're allowed to carry the excess forward for use in future years. There's no time limit for using the capital loss deductions that you've carried forward.

How short- and long-term capital gains and losses work

The tax laws distinguish between short- and long-term capital gains and losses. If you've held an investment for longer than a year, then any gain or loss is long term. If you've owned the investment for a year or less, then gains or losses are short term.

In calculating your capital loss deduction, you first offset short-term capital gains against short-term capital losses and long-term capital gains against long-term capital losses. If both net results are gains, then you report and pay taxes on them accordingly. If both are losses, then you can use them to offset ordinary income, using the short-term losses first. If one figure is a gain and the other is a loss, then use them to offset each other. Whatever remains retains its character. So if you end up with a net long-term loss that's bigger than the net short-term gain, then you'll keep the difference as a long-term loss. Conversely, if a long-term gain is bigger than a short-term loss, then the excess will be treated as a long-term gain.

Be careful with losses

Finally, keep in mind that there are rules that govern when you're allowed to claim a capital loss. To trigger a gain or a loss, you have to sell the investment in question. With losses, there's an additional restriction called the wash sale rule. In order to claim a loss, you must not buy back the investment that you've sold within the first 30 days after the sale. If you do so, then your capital loss is disallowed, and you're not allowed to claim it as a deduction.

Losing money on an investment is a bad thing. But with the capital loss deduction, you can at least get a portion of those losses back through the taxes you'll save. That's a silver lining that's worth the effort to get.

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