Why do we allow investors to deduct stock market losses from their taxes?

This is just one in the “I’ve Always Wondered” series. This series will answer all your questions about the world of business, big and small.What is recycling worth it? or how to store the brand pile up name brand?See more in the series here.

Listener and reader John Wang from Eden Prairie, Minnesota asks:

Why are stock market losses tax deductible? We the public seem to provide insurance or indirectly fund the risky bets of individual investors.

Wall Street just finished its worst year since the Great Recession.

By the fall, U.S. households had lost nearly $9 trillion in assets as stocks fell amid decades of high inflation and rising interest rates.

As investors head into tax season, they will be able to offset some of their losses. However, there are rules governing the types of investment losses that can be deducted and limits on the amount that can be deducted.

Since the introduction of the modern income tax system in 1913, capital losses and how they are handled have actually been the subject of debate for more than a century, according to a Congressional Research Service report.

“Over the past 100 years, there has been a broad consensus that it is not fair to tax capital gains without considering capital losses,” said Janice Traflett, a professor of accounting and financial management at Bucknell University. rice field.

First, here’s how capital losses work

When you sell an investment, such as a stock or bond, for less than its cost, it counts as a “capital loss.” Losses must also be “realized”. In other words, a mere decrease in the value of an investment cannot be tax deductible. You really have to sell.

Capital gains and losses fall into two time-based categories: short term (meaning the asset has been held for less than one year) or long term (meaning the asset has been held for more than one year).

Capital losses can be deducted against capital gains, thus reducing overall tax liability.

But losses must first offset gains within the same category. According to Bankrate, “short-term losses offset short-term gains first, and long-term losses offset long-term gains first”. can.

This is because the short-term capital gains tax rate (the same tax rate as on ordinary income) is different from the long-term capital gains tax rate (either 0%, 15%, or 20%, depending on income or filing). It is important. status). That’s at least in part because governments want to encourage investors to keep investing, and discourage buying and selling “hot stocks.” In fact, couples making less than her $83,350 a year who file jointly are lucky enough to have a long-term tax rate of 0%.

Now subtract capital losses from capital gains. But what if the losses outweigh the gains? Or what if there were no capital gains in the first place?

After that, you can deduct a $3,000 loss from your income each year, but if you’re married and file separate tax returns, the limit is $1,500. If your capital loss exceeds the $3,000 cap, you can claim additional losses in the future.

For example, if you have a net capital loss of $10,000 and you’ve offset $3,000, you’re left with $7,000 that you can carry forward to offset future capital gains or income, Bucknell University’s Traflett explained.

Here’s why the US allows you to deduct some of your losses:

Rules governing capital losses have existed in various forms for decades. According to a Congressional Research Service report, between 1913 and 1916, capital losses were deductible only if they “related to the taxpayer’s transaction or business.” From 1916 to 1918, losses were deductible against capital gains even if they were not business related.

The Revenue Act of 1918 allowed for an “unlimited loss deduction” as a temporary move. Since 1924, “tax law provided for partial, but not full, deductions for capital losses,” Traflet said.

During the Great Depression, a distinction between short-term and long-term tax treatments and the concept of loss carry-forwards were introduced, but “partial deductions of capital losses were still dominated,” Traflet added. Investors who suffered huge real losses in the Great Depression would have wanted to return to the brief era of full deductions for capital losses.”

In the decades that followed, further changes continued to unfold.

Mihir Desai, a professor at Harvard Business School and Harvard Law School, also said the deduction is intended to treat taxpayers fairly.

“All tax systems try to figure out each person’s ability to pay,” says Desai. “The more income you have, the more solvency you have, so you should be taxed more. Losses are the same. .”

Both Traflet and Desai said our tax regime actually limits our ability to deduct losses. According to Desai, a “fair” argument for raising the $3,000 limit is that this amount has remained the same for decades and doesn’t take into account inflation.

Desai said that, in theory, taking risks gives people the opportunity to build businesses, which is “a source of economic growth.” “Risk-taking is how capitalism works, so there is no reason to punish it,” says Desai. In that sense, allowing people to mitigate some of their investment losses through tax credits contributes to a healthy economy.

However, he said there are some forms of risk-taking that others find “ridiculous”.

“It’s difficult to distinguish between different types of risk-taking,” he said. “It seems like a silly risk-taking to me, but it could be your dream.”

“Manufacturing Loss” for Tax Advantage

Since there are limitations on deductions for capital losses, Desai wanted to turn the issue around by asking:

“The reason is that people are starting to worry that they are using different devices to basically create losses,” he said.

Desai said there are “legitimate” and “problematic” ways for investors to take advantage of tax-deductible losses.

Under the current “realization-based system,” where stock earnings received are taxed, one might postpone paying those taxes while waiting for profits to be harvested, but sell losses quickly and sell them sooner. You can make it deductible. “It’s kind of opportunistic,” he said, even though it’s built into our system.

But there are more “harmful forms” of this, says Desai.

Here’s an example of a scenario that the IRS struggled with before the 1986 Tax Reform Act. Desai said that if he’s wealthy and making a lot of money, his one way of manipulating the system is to become a partner in a venture in the know. You can use that loss to offset your taxable income.

According to a paper by economist Andrew Samwick, investments aimed at generating tax losses are known as tax shelters.

“Otherwise, high-income taxpayers could, with little direct effort, use tax shelter losses to lower their average tax rate than low-income taxpayers without tax shelter losses. can,” Samwick wrote.

IRS rules, derived from the 1986 tax law, limit your ability to deduct losses if you do not “substantially participate” in the business.

“However, it is very difficult to police this use of passive loss,” said Desai. “Here’s another version of why we’re really worried about investment losses.”

The “wash sale” rule is another attempt to counter manipulation. The Internal Revenue Service prohibits the deduction of losses on the sale of securities if the same security is purchased within 30 days before or after the sale.

Overall, therefore, the United States has a balanced system for the tax treatment of investment losses. It allows them to be deducted, but it also doesn’t “subsidize” them, Desai said.

In other words, Uncle Sam feels your pain, but most of the time you are alone.

A lot is happening in the world. All in all, Marketplace is for you.

Use the Marketplace to analyze world events and tell them how they affect you in a factual and friendly way. To keep it possible, we rely on your financial support.

Your donation today will power the independent journalism you rely on. For just $5/month, you can help us maintain the Marketplace. This allows us to keep you informed of what is important to you.

Source link

Leave a Reply

%d bloggers like this: