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What Is a Capital Loss Deduction?

Terry Masters
Terry Masters

A capital loss deduction is a reduction in taxable income that is allowed by a tax authority to offset a decrease in the value of an asset. Many countries and regions tax income, including income from the appreciation in the value of all types of assets. An item's income is determined at the point it is sold or transferred to another party by comparing the sales price to the original purchase price when the asset was acquired. The change in value is either a capital loss or a capital gain. If the sale results in a loss, many jurisdictions allow the amount of the loss to be deducted from other income.

Every jurisdiction has its own tax code that reflects the way it taxes its residents. These codes detail how assets are treated for income tax purposes in those jurisdictions that assess an income tax. Assets are all of the things that an individual or entity owns, including real estate, personal property and investments. Tax codes refer to these items as capital assets and designate rules for determining how to tax the appreciation in the value of the asset over time.

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A capital asset can either increase or decrease in value over time. If the asset increases in value, the owner must pay capital gains taxes on the increase during the year he sells or transfers the item. It is also possible for an asset to decrease in value. Decreases result in capital losses and can generate tax benefits in the form of deductions from other income in the amount of the loss. This results in the owner paying less overall taxes to compensate him for suffering the loss.

The rules that govern a capital loss deduction can be different in every jurisdiction. In the US, for example, a capital loss deduction can be applied to other income, such as wages, up to a certain amount. If the loss is more than the allowable deduction for the year, the balance can be carried over and applied to income in the next year and subsequent years, until the loss is completely allocated. In some instances, this can be a significant benefit to a taxpayer that completely offsets the financial impact of an asset losing value.

Another typical restriction on a capital loss deduction in a jurisdiction like the US is limiting the deduction to investment property. If a loss is realized on an item of personal property, like a car, the owner cannot take a capital loss deduction. The deduction only applies to property held for investment purposes, such as stock, bonds and rental real estate.

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