I was listening to a debate on the radio today regarding the need to raise the capital gains rates. Of course it was pointed out that Warren Buffet ones suggested the need to do this since his secretary ends up paying a higher rate than he does. Anyway, I started thinking, why is it that there is so much discussion regarding capital gains but capital losses are never brought into the debate? Just to summarize the issue, capital gains are the tax paid on investment appreciation when it is sold. So for instance you buy a stock or mutual fund for $10,000 and three years from now you sell it when it is worth $15,000, you would pay capital gains tax on the $5,000 gain. For most people this gain would be taxed at 15% by the federal government. Many argue that this is not fair since ordinary income rates, the rates on your wages and self employment income, are progressively more (for 2011 they are 10%, 15%, 25%, 28%, 33%, 35%). The argument is that wealthier people have much more income from capital gains than middle class and poor families.
There has been a lot of debate for and against the lower capital gains rates but I don't see anything mentioned regarding capital losses. As can be inferred, capital losses would be the recognized losses on investment depreciation. So using our example above, if you buy the stock for $10,000 and three years from now you sell it when it is only worth $5,000, you have a capital loss of $5,000. Now this is where it gets interesting (or not). Capital losses offset (lower) any capital gains you have for the year but if you end up with more losses than gains, only $3,000 of the capital loss can offset ordinary income per year. Any amount over $3,000 has to be carried forward to future years. So going back to our example, only $3,000 of the $5,000 loss would be used this year to lower, say, our employment income. The remaining $2,000 is carried forward to next year where it will first lower any capital gains we may have, and then our ordinary income.
So how is this relevant to the discussion on capital gain rates? Well, lets say you invest heavily in the stock market but make some really bad decisions. Your investments go south and you end up losing $150,000. You sell everything, take your loses and vow never to participate in the stock market again. Since you can only take $3,000 a year in capital losses against your other income, it will take you 50 years to use up the losses on your tax returns. So if your in your 50's and 60's, chances are you would never use them up. I know an individual who went through this sort of thing but his losses were actually quite a bit more.
My point is simple, though capital gains rates are lower than ordinary income rates, there are major restrictions on using capital losses. Any debate on raising the capital gains rates need to take this into consideration.