CRS Reports on Capital Loss Treatment

The Congressional Research Service (CRS) has released a report analyzing the effects of a proposed increase in the net capital loss limitation.

Currently, noncorporate taxpayers can net capital gains and losses and can use up to $3,000 in capital loss to offset ordinary income for that tax year (IRC § 1211(b)). Net losses over the $3,000 limit can be carried forward and used in future tax years (IRC § 1212(b); Treas. Reg. § 1.1212-1(b)).

One effect of this treatment is that long-term capital gains are taxed at 15%, but net long-term losses can be used to offset income taxed at higher rates. The CRS notes that this allows taxpayers to “game the system” by selectively recognizing capital gains or losses in a particular year in order to minimize their overall tax burden. The loss limitation is designed to minimize this strategy.

The $3,000 limit has not increased since 1978, and from time to time proposals are made to increase it. On Feb. 13, Rep. Walter Jones (R-N.C.) introduced H.R. 1070, which would increase the limit to $10,000. That bill has been referred to the House Ways and Means Committee.

The CRS report (Hungerford and Gravelle, “An Analysis of the Tax Treatment of Capital Losses” (CRS 2009)) notes that several reasons have been advanced for increasing the capital loss limitation, including economic stimulus and restoring investor confidence. The report concludes that increasing the limit would have an uncertain and indirect effect on the economy and might even lower the stock market in the short term by encouraging investors to sell.

The report also notes that upper-income taxpayers have the most capital gains income. For example, in 2006, the top 3% of taxpayers earned 91% of capital gains reported on Form 1040, Schedule D (IRS, Statistics of Income Bulletin (2006)). The report assumes that upper-income taxpayers also have the most capital losses.

Middle-income taxpayers tend to hold onto their investments in retirement accounts, which are not affected by the net loss restrictions. Therefore, any increase in the capital loss limitation would mostly benefit wealthy taxpayers.

This report follows up on a similar CRS report from 2002 (Esenwein and Gravelle, “An Analysis of the Tax Treatment of Capital Losses” (CRS 2002)). The earlier report was released at a time when President Bush was proposing to increase the limitation to $20,000.