Investment Losses and Taxes: What Investors Need to Know for 2022
Monday April 18, 2022 is right around the corner and many investors are considering how to treat their 2021 investment losses, especially from ponzi schemes, for tax purposes. The following is an educational reference, which should not take the place of professional advice.
Investment Losses Caused by Ponzi Schemes
Fortunately, the tax code does provide some relief for investors who have been swindled by Ponzi schemes and other methods of theft of their funds. Generally speaking, section 165 of the Internal Revenue Code (I.R.C.) allows for deducting losses of any other kind, including losses from theft (i.e. a ponzi scheme).
It is necessary to demonstrate the alleged theft as a theft under the meaning of the laws of that jurisdiction. That means that there must have been actual removal or criminal appropriation of property, with criminal intent, and that it was illegal under the law of the jurisdiction in which it occurred. It is also necessary to show that there is no reasonable prospect of retrieval, within that year, of the property that was stolen. The taxpayer must also identify precisely how much was lost to theft.
This can all be very difficult to prove and sometimes it might be easier to hire an attorney to rather seek compensatory damages from the thieving party or from some equally responsible party (such as an advisory firm that should’ve had warning systems in place to detect the theft) in order to be reimbursed for losses.
Short v. Long Term Investment Losses
Gains made from investments or the sale of capital assets are subject to capital gains tax. Generally speaking, the amount gained is the amount you received for the asset in the sale minus the adjusted basis of the asset.
An “adjusted basis” is the original cost of an asset adjusted according to certain financial events. Calculating the adjusted basis depends on the type of asset being calculated and how it was acquired, for example, whether through inheritance or purchase.
Just as there are capital gains, there are also capital losses. A capital loss is recorded when the amount received for selling an asset is less than its adjusted basis.
For example, if you buy one Bitcoin at $50,000 and then sell it at $40,000, you have suffered a capital loss of $10,000. This loss can be used to offset your capital gains tax bill.
Generally speaking, there are two broad categories of capital losses – long and short term. Long-term investment losses are usually for assets that you have held for more than a year, and short-term gains are for those that you have held for less than that. There are some exceptions to this rule such as gifts, commodity futures, bequeathals, patent property, and applicable partnership interests.
Short-term investment losses are taxed at ordinary income tax rates. These rates are determined based on how much you earn and your filing status (e.g., single, married filing jointly, married filing separately, or head of household).
Broadly, long-term capital gains taxes are usually lower than the tax you pay on your ordinary income. Long-term investment gains can also usually be offset by long-term investment losses, and carryovers of long-term losses from previous years are allowed.
Most long-term capital gains are taxed at no more than 15%. For single individuals whose taxable income is less than $40,400—or for married people filing jointly and qualifying widow(er)s whose taxable income is less than $80,800—some capital gains have no tax on them at all.
The tax rate is 20% if your taxable income is higher than the threshold for the 15% rate. The current thresholds for the 20% rate are:
- Single – Over $445,850
- Married filing jointly – Over $501,600
- Married filing separately – Over $250,800
- Head of household – Over $473,750
What is Tax Loss Harvesting?
Tax Loss Harvesting is a practice undertaken by some investors to accumulate timely investment losses so they can offset any gains for the same time period. This is done by selling certain securities at a loss when the time is right.
This tax strategy is almost always used to offset short-term gains only, not long-term.
If your capital losses exceed your capital gains, thereby putting you at a net loss, you are generally allowed to use as much as $3,000 of that loss to reduce your income. You can then carry the remainder of the loss over to the following year.
What is the Wash Sale Rule?
One caveat investors must be aware of is the Wash-Sale rule.
If you sell investments at a loss and then repurchase those same investments within 30 days, the sale is deemed a Wash-Sale which wipes out any claimable capital losses suffered by the initial sale. To be able to claim a capital loss, investors must wait at least 31 days before buying any assets that they sold at a loss previously.
It doesn’t even have to be the same asset. It can be an asset that is “substantially identical.” The matter can get pretty murky. Offloading 100 shares of Apple and replacing them with 100 shares of Tesla won’t be considered substantially identical. But what about if you replace an index fund with a managed fund? Or if you replace one S&P Index Fund with another. It starts to get hazy, so consulting with a tax adviser is highly advisable.