What it is:
How it works (Example):
The formula for capital loss is:
Purchase Price - Sale Price = Capital Loss
Let's assume you purchase 100 shares of XYZ Company for $5 per share. After three months, the share price decreases to $1. This means the value of the investment has decreased from $500 to $100, for a capital loss of $400.
Why it Matters:
Capital losses are generally tax deductible, but only when they are realized. That is, they only become deductible when the asset is actually sold (unless the stock is legally deemed worthless). Until that point, any losses are considered unrealized and are not deductible. The IRS considers nearly every asset owned by individuals and companies as capital assets and thus subject to capital gains taxes and capital loss deductions.
Taxpayers report capital losses on IRS Schedule D. An investor's capital losses will sometimes offset all or a portion of his or her capital gains, lowering the investor's tax bill. There is a limit to how much the investor can offset (generally $3,000), but remaining losses can typically be carried over to future tax years. To prevent trading for the sole purpose of tax avoidance, the wash sale rule prevents investors from deducting capital losses on a security if they purchased a "substantially identical security" within thirty days before or after the sale.
Many analysts claim that the deductibility of capital losses encourages tax-loss selling during November and December of each year, which in turn fuels the "January effect," which is a tendency for the market to rise during that month. Analysts believe this is the case because the wash sale rule requires investors who sell stock for tax-losses in November and December to wait at least thirty days to repurchase those shares.