An Analysis of the Tax Treatment of Capital Losses (CRS Report for Congress)
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| Release Date |
Revised Sept. 30, 2022 |
| Report Number |
RL31562 |
| Report Type |
Report |
| Authors |
Thomas L. Hungerford, Specialist in Public Finance; Jane G. Gravelle, Senior Specialist in Economic Policy |
| Source Agency |
Congressional Research Service |
| Older Revisions |
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Summary:
Several reasons have been advanced for increasing the net capital loss limit against ordinary income: as part of an economic stimulus plan, as a means of restoring confidence in the stock market, and to restore the value of the loss limitation to its 1978 level. Under current law, long-term and short-term losses are netted against their respective gains and then against each other, but if any net loss remains it can offset up to $3,000 of ordinary income each year. Capital loss limits are imposed because individuals who own stock directly decide when to realize gains and losses. The limit constrains individuals from reducing their taxes by realizing losses while holding assets with gains until death when taxes are avoided completely.
Current treatment of gains and losses exhibits an asymmetry because long-term gains are taxed at lower rates, but net long-term losses can offset income taxed at full rates. Individuals can game the system and minimize taxes by selectively realizing gains and losses, and for that reason the historical development of capital gains rules contains numerous instances of tax revisions directed at addressing asymmetry. The current asymmetry has grown as successive tax changes introduced increasingly favorable treatment of gains. Expansion of the loss limit would increase "gaming" opportunities. In most cases, this asymmetry makes current treatment more generous than it was in the past, although the capital loss limit has not increased since 1978.
Capital loss limit expansions, like capital gains tax benefits, would primarily favor higher income individuals who are more likely to hold stock. Most stock shares held by moderate income individuals are in retirement savings plans (such as pensions and individual retirement accounts) that are not affected by the loss limit. Statistics also suggest that only a tiny fraction of individuals in most income classes experience a loss and that the loss can usually be deducted relatively quickly.
One reason for proposing an increase in the loss limit is to stimulate the economy, by increasing the value of the stock market and investor confidence. Economic theory, however, suggests that the most certain method of stimulus is to increase spending directly or cut taxes of those with the highest marginal propensity to consume, generally lower income individuals. Expanding the capital loss limit is an indirect method, and is uncertain as well. Increased capital loss limits could reduce stock market values in the short run by encouraging individuals to sell.
Adjusting the limit to reflect inflation since 1978 would result in an increase in the dollar limit to about $10,000. However, most people are better off now than they would be if the $3,000 had been indexed for inflation if capital losses were excludable to the same extent as long-term capital gains were taxable. For higher income individuals, restoring symmetry would require using about $2 in long-term loss to offset each dollar of ordinary income. Fully symmetric treatment would also require the same adjustment when offsetting short-term gains with long-term losses. This report will be updated to reflect legislative developments.
