Netting Capital Gains and Losses

The IRS requires taxpayers to follow a specific netting process when reporting capital gains and losses on Schedule D. Understanding this process is critical for accurately calculating tax liability and is frequently tested on the EA exam.

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The Three-Step Netting Process

Capital gains and losses must be netted in a precise order. Think of it as a three-step calculation:

Step 1: Net Short-Term Gains Against Short-Term Losses

First, combine all short-term capital gains (assets held one year or less) with all short-term capital losses to arrive at your net short-term capital gain or loss.

Schedule D, Part I (Lines 1-7):

• Line 1-3: Short-term transactions from Form 8949
• Line 4: Short-term gain from installment sales (Form 6252)
• Line 5: Short-term gain/loss from like-kind exchanges (Form 8824)
• Line 6: Short-term capital loss carryover from prior year
• Line 7: Net short-term capital gain or (loss)

Step 2: Net Long-Term Gains Against Long-Term Losses

Next, combine all long-term capital gains (assets held more than one year) with all long-term capital losses to arrive at your net long-term capital gain or loss.

Schedule D, Part II (Lines 8-15):

• Lines 8-10: Long-term transactions from Form 8949
• Line 11: Gain from Form 4797 (Section 1231 gains)
• Line 12: Long-term gain from installment sales
• Line 13: Long-term gain/loss from like-kind exchanges
• Line 14: Long-term capital loss carryover from prior year
• Line 15: Net long-term capital gain or (loss)

Step 3: Combine Net Short-Term and Net Long-Term

Finally, combine the net short-term amount (Line 7) with the net long-term amount (Line 15) to determine your overall net capital gain or loss.

Schedule D, Part III:

• Line 16: Total net gain or (loss) = Line 7 + Line 15

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The $3,000 Capital Loss Limit

Unlimited Losses Against Gains

There is no limit on using capital losses to offset capital gains. If you have $100,000 in capital gains and $150,000 in capital losses, you can use all $100,000 of losses against your gains.

$3,000 Limit Against Ordinary Income

The limitation applies only when net capital losses exceed net capital gains. In this situation:

Important: The $1,500 limit for Married Filing Separately (MFS) is one of the few "split-in-half" provisions in the tax code—memorize this for the EA exam!

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Comprehensive Netting Example

Facts: In 2024, Taylor has the following capital transactions:

Step 1: Net Short-Term

• Short-term gains: $5,000
• Short-term losses: ($8,000)
• Net short-term: ($3,000) loss

Step 2: Net Long-Term

• Long-term gains: $12,000
• Long-term losses: ($3,000)
• Net long-term: $9,000 gain

Step 3: Combine

• Net short-term loss: ($3,000)
• Net long-term gain: $9,000
• Total net capital gain: $6,000

Result: Taylor has a $6,000 net long-term capital gain, taxed at preferential rates (0%, 15%, or 20% depending on income). The short-term loss reduced the long-term gain but did not eliminate it.

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Capital Loss Carryover Rules

Indefinite Carryforward Period

When net capital losses exceed the $3,000 annual limit, the excess carries forward indefinitely to future tax years. There is no expiration date for capital loss carryovers.

Character Preservation

This is a critical rule: Carryover losses retain their original character.

• Short-term losses carry forward as short-term capital loss carryovers
• Long-term losses carry forward as long-term capital loss carryovers

This character preservation is important because it affects which type of gains the carryover will offset in future years and the resulting tax rate.

Ordering Rules for Carryover Calculation

When determining the carryover amount, the IRS applies losses in a specific order:

1. Short-term losses are used first against the $3,000 ordinary income deduction
2. Long-term losses are used second if short-term losses are insufficient

This ordering rule is applied through the Capital Loss Carryover Worksheet in the Schedule D instructions.

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Capital Loss Carryover Example

Facts: In 2024, Marcus (single filer) has:

• Net short-term capital loss: ($7,000)
• Net long-term capital loss: ($5,000)
• No capital gains
• Total net capital loss: ($12,000)

2024 Tax Treatment:

• Marcus deducts $3,000 against ordinary income
• Carryover to 2025: $12,000 - $3,000 = $9,000

Carryover Character Calculation (using IRS ordering rules):

2025 Schedule D Entry:

• Line 6 (Short-term loss carryover): $4,000
• Line 14 (Long-term loss carryover): $5,000

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Using Carryover Losses in Future Years

In future years, carryover losses follow the same netting process:

1. Short-term carryover offsets short-term gains first
2. Long-term carryover offsets long-term gains first
3. If net amounts differ in sign, they offset each other
4. Any remaining net loss is limited to $3,000 against ordinary income

Example Continuation: In 2025, Marcus has:

• Short-term capital loss carryover from 2024: $4,000
• Long-term capital loss carryover from 2024: $5,000
• New short-term gain: $6,000
• New long-term gain: $10,000

2025 Netting:

• Net short-term: $6,000 - $4,000 = $2,000 gain
• Net long-term: $10,000 - $5,000 = $5,000 gain
• Total: $7,000 net capital gain (taxed at preferential rates)

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Schedule D Reporting Summary

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Special Rules for Married Taxpayers

Joint to Separate Returns

If you filed jointly in a prior year and are filing separately this year:

• Each spouse can only deduct losses that were actually theirs
• You cannot split the carryover 50/50 unless it was actually incurred equally

Death of a Taxpayer

Capital loss carryovers cannot be transferred to a surviving spouse or beneficiaries. They expire upon death. This is different from net operating losses, which have different rules.

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EA Exam Tips

1. Memorize the netting order: Short-term vs. short-term first, long-term vs. long-term second, then combine.

2. Know the limits by filing status: $3,000 for most filers, $1,500 for MFS.

3. Character preservation is key: Watch for questions testing whether carryover losses remain short-term or long-term.

4. No limit against gains: The $3,000 limit only applies to ordinary income deduction, not to offsetting capital gains.

5. Carryforward is indefinite: Unlike NOLs with their own rules, capital loss carryovers never expire (except at death).

6. Short-term losses first: When calculating carryover amounts, short-term losses are applied against the $3,000 deduction before long-term losses.