How to deduct inventory losses from your taxes
The Internal Revenue Service, or IRS, usually takes it, but sometimes it gives too. And so are all the inventory losses you incur. The tax authorities allow you to write off investment losses – called capital losses – on your income taxes, thereby reducing your taxable income and giving you a slight tax break in the process.
Here’s how to deduct inventory losses from your taxes and claim your tax relief.
Reversal of your loss: how it works
The IRS allows you to deduct from your taxable income a capital loss, for example on a stock or other investment that has lost money. Here are the basic rules:
- A loss of investment must be realized. In other words, you must have sold your stock to claim a deduction. You can’t just write off losses because the stock is worth less than when you bought it.
- You can deduct your loss from capital gains. Any taxable capital gain – an investment gain – realized in this tax year can be offset by a capital loss. If you have more losses than gains, you have a net loss.
- Your net losses make up for ordinary income. No capital gains? Your claimed capital losses will be deducted from your taxable income, which will lower your tax bill.
- Your maximum net capital loss for any tax year is $ 3,000. The IRS limits your net loss to $ 3,000 (for individuals and spouses filing jointly) or $ 1,500 (for the bride and groom separately).
- Unused capital losses are carried forward to future years. If you go over the $ 3,000 threshold for any given year, don’t worry. You can claim the loss in future years or use it to offset future gains, and the losses do not expire.
- You can reduce any amount of taxable capital gains as long as you have gross losses to offset them. For example, if you have a loss of $ 20,000 and a gain of $ 16,000, you can claim the maximum deduction of $ 3,000 on taxes in that year and the remaining loss of $ 1,000 in a future year. Again, for any year, the maximum allowable net loss is $ 3,000.
- The last day to realize a loss for the current calendar year is the last trading day of the year.. That day could be December 31, but it may be earlier, depending on the calendar.
You can list stock gains and losses on Schedule D of your annual income tax return, and the worksheet will help you calculate your net gain or loss.
It is also important to know that short-term losses outweigh short-term gains first, while long-term losses outweigh long-term gains first. However, once the losses in one category exceed the same type, you can use them to offset the gains in the other category. Short-term gains and losses relate to assets held for less than one year, while long-term gains and losses relate to assets held for more than one year.
Since short-term gains and long-term gains can be taxed at different rates, you will need to keep your gains and losses in order while you strategically plan your taxes.
In general, long-term capital gains are treated more favorably than short-term gains. You can therefore consider taking a loss sooner than you would otherwise, in order to minimize your taxes. Or you can try using long-term, low-tax gains to offset more heavily-taxed short-term gains.
In fact, many investors strategically plan when and how they will realize their losses and make sure to minimize their taxable income each year, typically by selling their losing investments towards the end of the tax year. It’s a process called harvesting tax losses, and it can save you real money.
The deduction of a loss has value only in a taxable account, and not in special tax accounts, such as IRAs and 401 (k), where capital gains are not taxed.
How much can you save?
So how much does the loss of inventory claim save you on your taxes? The answer to this question depends on your tax bracket and whether your loss is offsetting a taxable gain or ordinary income:
- If you offset a taxable gain with a loss, you save tax on the gains that you would otherwise have paid, and this figure can vary depending on whether the gain was long-term or short-term.
- If you claim a net loss, however, it’s easier to show how much you can save. Federal tax brackets range from 10% to 37%. So a $ 3,000 loss on stocks could save you up to $ 1,110 in the high end (37% * $ 3,000) or as little as $ 300, if you are in the low end.
And if you pay state taxes, you may be able to save 4 to 6 percent or more on top of these rates.
This kind of tax savings is the reason some people make sure to claim this loss every year.
Limits of the deduction – the rule of the wash sale
The IRS limits your ability to claim an inventory loss deduction, so you don’t mess with the system. The IRS won’t immediately let you write off what’s called a washing sale. A wash sale occurs when you take a loss on an investment and then redeem the investment within 30 days.
If you try to claim a wash sale as a deduction, the IRS will reject your deduction. Ultimately, you won’t lose the deduction, but you won’t be able to claim it until you’ve been out of the investment for at least 30 days after the loss. When you sell the redeemed shares later, or even years later, you can claim the loss.
And don’t try fancy footwork to try and dodge the rule. You cannot sell the shares and claim the loss, then ask your spouse to buy back the shares within 30 days. If your partner buys the stock within that 30 day window, you simply won’t be able to claim the loss.
Note that it is perfectly acceptable to sell an investment within 30 days and claim a loss. The key to selling washing is redemption the stock in this window.
However, you may be able to get away with some types of funds, for example those based on popular indices, such as the Standard & Poor’s 500. You may suffer a loss on one S&P 500 index fund but buy another, and you will still be able to claim your loss and stay invested. This method works because these two different funds track the same index, so they basically have the same holdings, but they are technically different funds.
At the end of the line
Deducting a loss of stock from your tax return can be a smart move to lower your taxable income, and some investors go out of their way to make sure they get the most out of this rule each year. However, you might want to be careful not to sell a stock just to get tax relief, if you think it’s a good long-term investment. Selling an otherwise good stock at a low point can mean that you are selling just when it is about to rebound.