Fixing the Capital Loss Tax Deduction for Financial Assets

Tax season is here! For me, it invariably evokes flaws in the tax code, one of which I will highlight in this post.

Specifically, I will discuss the outdated and inequitable treatment of capital loss deductions for stocks and bonds.

The Capital Loss Deduction: A One-Sided Deal

Imagine you buy 1,000 shares of Nvidia at $125 per share and later sell them for $150 per share. Your $25,000 profit is a capital gain. The government promptly taxes this gain.

But what happens if your investment tanks? If you sell those shares for $100 each, you suffer a $25,000 capital loss. It seems reasonable to expect that you could subtract this loss from your taxable income, just as the entire gain would be taxed.

However, the IRS allows you to deduct only $3,000 in capital losses per year from your ordinary income, such as wages. Any remaining loss must be carried forward to future years.

You can, however, use unlimited capital losses to offset capital gains in the same tax year. But, if you don’t have any capital gains to offset, it will take you over eight years to deduct the entire $25,000 loss.

The annual $3,000 deduction over several years is worth about $20,000 today at a 5 percent discount rate—much less than the $25,000 deduction if taken all at once—because a dollar today is worth more than a dollar in the future.

The Government Wins Both Ways

You would likely agree that the capital loss deduction rule is unfair. When we make gains, the government collects its share immediately. But when we experience losses, we must spread our deductions over an extended period.

An Outdated Rule in a Digital Age

When lawmakers passed the deduction limit in 1978, we primarily self-reported our stock transactions; it was challenging for the IRS to verify whether our reported losses were legitimate. To protect against fraudulent claims, it made some sense to cap the annual capital loss deduction.

However, today, brokerages electronically report all stock trades to the IRS. Given the reduced risk of fraudulent reporting, removing the deduction cap for publicly traded securities is defensible.

Asset sales, such as real estate, collectibles, cryptocurrencies, commodities, and business interests, generate capital gains/losses, but my proposal targets only stocks and bonds.

Why Focus on Publicly Traded Securities?

Allowing unlimited capital losses to offset taxable income could be abused for some assets, but this is less of a concern for publicly traded securities.

The market prices of publicly traded securities are objective and transparent, and taxpayers cannot manipulate them. Additionally, creating artificial losses is harder in public markets.

Moreover, the Wash Sale Rule prevents investors from exploiting tax loopholes by selling and repurchasing the same, or similar, security within 30 days to create an artificial loss.

Consequently, the rationale for the $3,000 cap no longer holds.

One concern is that investors will lower their tax bills by strategically exploiting capital loss deductions. However, these strategies are legal, and I don’t find them particularly worrisome.

A Hurdle: The Fear of Lost Tax Revenue

Legislators fear that eliminating the cap would cost billions in lost tax revenue. This short-term thinking ignores the potential for increased investment by letting investors recover their losses faster.

If investors could deduct full losses immediately, they’d be more willing to sell underperforming stocks and reinvest in better opportunities. Increased trading means more taxable gains, increased market activity, and a stronger economy—generating higher overall tax revenue in the long run.

A Limit Frozen in Time

If an unlimited capital loss deduction is too drastic and politically unpalatable, the existing deduction should, at a minimum, be adjusted for inflation.

Inflation has eroded the value of the $3,000 deduction, which is unchanged since its launch in 1978, by nearly 80 percent.

An inflation-indexed deduction would be approximately $14,500 today! For context, other tax thresholds, such as income tax brackets and the standard deduction, are already adjusted for inflation. 

Critics claim that raising the deduction limit would primarily benefit the wealthy. However, this claim overlooks the considerable stock ownership among middle-class Americans, who have a lower ability to absorb losses. Adjusting the deduction would benefit many taxpayers, not just the affluent.

A Sliding Age-Based Deduction

If a universal increase in the deduction limit is politically unfeasible, I propose an age-based tiered system as a pragmatic compromise. Consider this hypothetical example:

• Age Under 50: $3,000 deduction (current limit).
• Ages 50–64: $6,000 deduction.
• 65+: $10,000 deduction.

The above example presumes that older investors have a diminishing time horizon to recover from market downturns and rely more heavily on their investments for income.

For a 70-year-old who loses $25,000, waiting eight years for complete tax relief is unreasonable!

Increasing the limit for older taxpayers would enhance their financial security and make retirement planning more resilient.

Conclusion: A Tax Code, Lacking Fairness and Ripe for Change

The outdated capital loss deduction limit exemplifies a tax code that prioritizes revenue generation and political considerations over fundamental principles of fairness and consistency.

Lawmakers must either eliminate the cap on deductions for publicly traded financial assets or, at the very least, index it to inflation. This demand is not radical; it’s a matter of basic tax fairness!

 

Notes

• Capital Gains Tax Treatment

  • Short-term capital gains (held for one year or less) are taxed at ordinary income rates.
  • Long-term capital gains (held for over a year) are taxed at lower rates, offering some relief.

• Offsetting Capital Gains and Losses

  • Capital losses can fully offset capital gains in the same year.
  • If losses exceed gains, up to $3,000 can be deducted annually against ordinary income (for Married Filing Jointly).

• Inflation Erosion of the $3,000 Deduction

  • The $ 3,000 deduction inflation adjustment calculation: 319.08 CPI in 2024 × $3,000 / 65.2 CPI in 1978 = $14,681)
  • There’s a precedent of other tax thresholds (e.g., Alternative Minimum Tax) being inflation-adjusted later.

• Investor Impact

  • Market downturns (e.g., 2008 crash, 2022 bear market) leave many investors with significant capital losses.
  • Middle-class investors, often holding a few stocks, likely bear the brunt of the prolonged deduction cap.
  • Investors with assets in tax-advantaged accounts (401(k)s) are unaffected, as capital gains/losses don’t apply.