Why do we allow investors to deduct stock market losses from their taxes?

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Listener and reader John Wang from Eden Prairie, Minnesota, asks: 

Why are stock market losses tax deductible? It seems like we the people are providing insurance or indirectly funding private investors’ risky bets.

We’ve just exited Wall Street’s worst year since the Great Recession. 

By the fall, U.S. households had lost nearly $9 trillion in wealth as stocks declined amid decades-high inflation and rising interest rates. 

As investors head into tax season, they’ll be able to deduct some of their losses. But there are rules governing the types of investment losses you can deduct and caps on how much money you can write off. 

Capital losses, and how to treat them, have actually been subject to debate for more than a century, ever since the modern income tax system was put into place in 1913, according to a report from the Congressional Research Service.

“Over the past 100 years, there’s been a rough consensus that’s developed that it wouldn’t be fair to be taxing capital gains without taking some consideration of capital losses,” said Janice Traflet, an accounting and financial management professor at Bucknell University.

First, here’s how capital losses work

If you sell an investment, including stocks and bonds, for less than what it cost you, that counts as a “capital loss.” A loss also has to be “realized,” meaning that you can’t deduct it from your taxes if your investment has merely gone down in value. You have to actually sell it. 

Capital gains and losses are divided into two time-based categories: short term (meaning you’ve held the asset for one year or less) or long term (you’ve held it for more than a year). 

You can deduct capital losses against capital gains, lowering your overall tax bill.

But losses have to first offset gains within the same category. “Short-term losses offset short-term gains first, while long-term losses offset long-term gains first,” according to Bankrate. Any excess losses can then “offset gains in the other category.”

This matters because the short-term capital gain tax rate (the same rate as your tax bracket for ordinary income) is different from the long-term capital gain rate (either 0%, 15% or 20%, depending on your income or filing status). That’s at least in part because the government wants to encourage you to hold on to your investment, and it discourages in-and-out trading of “hot stocks.” In fact, if you’re a married couple who make $83,350 or less in annual income and you file jointly, your long-term rate is a lucky 0%. 

OK, so you deduct your capital losses against your capital gains. But what if your losses exceed your gains? Or what if you didn’t have any capital gains in the first place? 

You can then deduct $3,000 of your losses against your income each year, although the limit is $1,500 if you’re married and filing separate tax returns. If your capital losses are even greater than the $3,000 limit, you can claim the additional losses in the future. 

So for example, if you have a $10,000 net capital loss and you offset $3,000, that leaves you with $7,000 that you can carry over to offset future capital gains or income, Traflet of Bucknell University explained. 

Here’s why the U.S. allows you to deduct some of your losses

The rules governing capital losses have existed in different iterations through the decades. Between 1913 and 1916, capital losses were deductible only if they were “associated with a taxpayer’s trade or business,” according to the Congressional Research Service report. From 1916 to 1918, losses were deductible against any capital gains, even if they weren’t associated with your business.

The Revenue Act of 1918 then allowed “unlimited loss deductions,” a temporary move. By 1924 and onward, “tax law provided for partial, not full, deductibility of capital losses,” Traflet said.

During the Great Depression, the distinction between short- and long-term tax treatment and the notion of loss carryforwards were introduced, but “partial deductibility of capital losses still ruled,” Traflet added. “Undoubtedly, investors who incurred tremendous real losses in the Depression would have loved to have had a return to the brief era of full deductibility of their capital losses.”

Further changes continued to roll out in subsequent decades. 

Mihir Desai, a professor at Harvard Business School and Harvard Law School, also said that deductions are implemented with the aim of treating taxpayers fairly. 

“Every tax system tries to figure out what each person’s ability to pay is,” Desai said. “If you have more income, then you have more ability to pay, so you should be taxed more. A loss is similar. When you have a loss, you have less ability to pay. And so we think that it should function like a deduction.”

Both Traflet and Desai said our tax system actually restrains our ability to deduct losses. A “fair” argument one could make for increasing the $3,000 limit, Desai said, is that this amount has stayed the same for decades, failing to account for inflation. 

Desai said that in theory, risk-taking gives people the opportunity to build businesses, which is “a source of growth for the economy.” The argument goes that “risk taking is how capitalism works, so there’s no reason to penalize it,” Desai said. In that sense, allowing people to mitigate some of their investment losses through a tax deduction contributes to a healthy economy.

But, he said, there are some forms of risk-taking that others find “ridiculous.” 

“It’s hard to discriminate between different kinds of risk taking,” he said. “What looks like stupid risk taking to me might be your dream.” 

“Manufacturing losses” for tax advantage

Because of the limits put on capital loss deductions, Desai wanted to turn the issue on its head by asking: “Why don’t we just allow people to deduct all their investment losses?

“And the reason why is because then we start to worry that people will use lots of different devices to basically manufacture losses,” he said. 

There are “legitimate” and “problematic” ways investors can take advantage of tax-deductible losses, Desai said. 

Under our current “realization-based system” in which we’re taxed on stock earnings we’ve received, he said, you might wait to harvest your gains to defer paying those taxes but sell your losses right away so you can deduct them sooner. “That’s kind of opportunistic,” although it’s built into our system, he said. 

But there are more “pernicious forms” of this, Desai said. 

Here’s an example of a scenario the IRS struggled with prior to the Tax Reform Act of 1986. Desai said that if you were wealthy and earned a lot of money, one way to manipulate the system was to become a partner in a venture that you knew would lose money, allowing you to use those losses to offset your taxable income. 

Investments aimed at creating losses for tax purposes are known as tax shelters, according to a paper from economist Andrew Samwick.

“An otherwise high-income taxpayer could, with very little direct effort, utilize tax shelter losses to lower his or her average tax rate below that of a low-income taxpayer without tax shelter losses,” Samwick wrote. 

IRS rules stemming from the 1986 tax law limit your ability to deduct losses if you do not “materially participate” in that business. 

“But it’s really hard to police against this use of passive losses,” Desai said. “That’s the other version of why we are really worried about investment losses.” 

The “wash-sale” rule is another attempt to combat manipulation. The Internal Revenue Service prohibits you from deducting losses on the sale of a security if you have purchased that same security within 30 days before or after the sale. 

So overall, the U.S. has a balanced system for the tax treatment of investment losses. It allows them to be deducted, but it doesn’t “subsidize” them either, Desai said.

In other words, Uncle Sam feels your pain, but for the most part, you’re on your own.