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

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

Why are stock market losses tax deductible? It seems that we the people insure or indirectly fund the risky bets of private investors.

We have just come out of the worst year on Wall Street since the Great Depression.

By fall, American households had lost nearly $9 trillion in wealth as stocks plummeted amid decades of high inflation and soaring interest rates.

As investors head into tax season, they will be able to deduct some of their losses. But there are rules that govern what types of investment losses you can deduct and how much money you can write off.

Capital losses and how to treat them have been the subject of virtually debate for more than a century, ever since the modern income tax system was devised in 1913, according to a report by the Congressional Research Service.

“Over the past 100 years, there has been a rough consensus that has developed that it would not be fair to tax capital gains without taking into account some capital losses,” said Janice Travellett, professor of accounting and financial management at Bucknell University.

First, here’s how capital losses work

If you sell an investment, including stocks and bonds, for less than it cost you, it is a “principal loss.” The loss must also be “realized,” meaning you can’t deduct it from your taxes if your investment has only decreased in value. You have to actually sell it.

Capital gains and losses fall into two time categories: short term (meaning you held the asset for a year or less) or long term (meaning you held it for more than a year).

You can deduct capital losses for capital gains, which lowers your total tax bill.

But the losses must first offset the gains within the same category. “Short-term losses offset short-term gains first, while long-term losses offset long-term gains first,” according to Benkrit. Any excess losses can “offset gains in the other category”.

This is important because the short-term capital gains tax rate (the same rate as your tax bracket for ordinary income) is different from the long-term capital gains rate (either 0%, 15%, or 20%, depending on your income or filing state). This is at least in part because the government wants to encourage you to hold your investment, and discourages inside and outside trading of “hot stocks”. In fact, if you’re married making $83,350 or less in annual income and you file jointly, your long-term rate is 0% lucky.

Okay, so you deduct your capital losses against your capital gains. But what if your losses exceed your gains? Or what if you didn’t have any capital gains in the first place?

You can then deduct $3,000 of your losses against your income each year, although the maximum is $1,500 if you’re married and file separate tax returns. If your capital losses are greater than the $3,000 limit, you can claim the additional losses in the future.

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

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

The rules governing capital losses have existed in various iterations over the decades. Between 1913 and 1916, capital losses were only deductible if they were “related to the taxpayer’s trade or business,” according to a Congressional Research Service report. From 1916 to 1918, losses were deductible against any capital gains, even if they were not related to your business.

Then the Revenue Act of 1918 allowed for an “unlimited loss deduction,” a temporary move. By 1924 and later, Travellett said, “the tax code provided for a partial, rather than a full, deduction for capital losses.”

During the Great Depression, the distinction between short- and long-term tax treatment and the concept of a carry-forward loss was introduced, but “the partial deduction for capital losses still predominates,” Travlett added. Undoubtedly, investors who had taken huge real losses in the Depression would have liked to go back to the short era of full deductions for their capital losses.

Additional changes continued to appear in subsequent decades.

Mihir Desai, a professor at Harvard Business School and Harvard Law School, said the deductions are being implemented with the aim of treating taxpayers fairly.

“Every tax system tries to figure out what everyone’s ability to pay,” Desai said. “If you have more income, you have more ability to pay, so you should be taxed more. Losing is the same. When you have a loss, your ability to pay decreases. And so we think it should work as an adversary.”

Both Travellet and Desai said our tax system already restricts our ability to deduct losses. A “fair” argument one can make for increasing the $3,000 limit, Desai said, is that that amount has been sitting the same for decades, failing to account for inflation.

In theory, risk-taking gives people the opportunity to build businesses, Desai said, which is “a source of growth for the economy.” The argument, Desai says, is that “risk is the way capitalism works, so there is no reason to punish it.” In this sense, allowing people to mitigate some of their investment losses through tax deduction contributes to a healthy economy.

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

“It’s hard to distinguish between the different types of risk,” he said. “What seems like a stupid risk to me could be your dream.”

“Manufacturing losses” for a tax advantage

Because of the limitations on capital loss deductions, Desai wanted to turn the issue on its head by asking, “Why don’t we just let people deduct all their investment losses?”

“And the reason for that is because we’re starting to worry that people are going to use a lot of different devices to basically manufacture losses,” he said.

Desai said there are “legitimate” and “problematic” ways in which investors can benefit from tax-deductible losses.

Under our “current inquiry-based system” in which we are taxed on dividends received, he said, you might wait to take your gains to defer paying those taxes but sell your losses immediately so you can deduct them sooner. “That’s kind of opportunistic,” he said, even though it’s built into our system.

But there are more “malignant forms” to this, Desai said.

Here is an example of a scenario the IRS faced prior to the 1986 tax reform law. Desai said that if you are wealthy and make a lot of money, one way to game the system is to become a partner in a venture that you know could lose money, allowing you to use those losses to recoup Your taxable income.

Investments that are intended to generate losses for tax purposes are known as tax shelters, according to a paper from economist Andrew Samwick.

“High-income taxpayers can, with very little direct effort, take advantage of tax shelter losses to reduce their average tax rate below the tax rate of lower-income taxpayers without tax shelter losses,” Samwick wrote.

IRS rules stemming from the 1986 Tax Code limit your ability to deduct losses if you did not “actually participate” in the business.

“But it’s really hard for the police to be against this use of negative casualty,” Desai said. “This is the other version of why we’re really concerned about investment losses.”

The “sell – wash” rule is another attempt to combat manipulation. The Internal Revenue Service prevents you from deducting losses from selling a security if you purchased the same security within 30 days before or after the sale.

So, in general, the United States has a balanced system for the tax treatment of investment losses. Desai said he allows them to be discounted, but he doesn’t “support” them either.

In other words, Uncle Sam feels your pain, but for the most part, you’re on your own.

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