Every year, companies calculate their annual profits and losses by preparing a set of statements that are collectively termed as the final accounts of the company. While preparing these statements, there are several adjustments that have to be taken into consideration. For example, the company has to derive: how much total tax has to be paid for that very accounting year. Carryover of capital loss is a concept that is closely related to tax and finance management. This concept proves to be useful for organizations and individuals, when they are planning their tax and finances, while closing their books of accounts.
Definition and Meaning
Large size corporations often incur certain losses in business, which are sustained for a certain period of time and are eventually recovered. Capital loss, in layman’s language, is often defined as a substantial loss in business. There is no specific cause for it, and a variety of reasons can be cited. For example, sale of an asset at a value, lesser than the book value, can be defined as it. Such losses are totaled by the end of the year when the profit and loss statement is completed. If their total monetary value is greater than that of the profits, then the company is said to have incurred a “net capital loss.”
In the US, according to the guidelines and carryover rules that are issued by the IRS and department of revenue, the amount of profit or income that can be taxed is reduced as a result of the capital loss. However, there is a certain limit to the amount that can be considered as a valid ground for tax deductions. In most of the cases, the limit is USD 3,000. It basically means that any individual or organization cannot claim a tax deduction for more than USD 3,000. So, what about the amount that exceeds USD 3,000? Here is where carryover comes into the picture. It basically means that the amounts exceeding USD 3,000 are carried forward, and tax deduction can be claimed on the basis of this amount.
How does Carryover Work?
Let’s take an example: imagine that you have a net capital loss of USD 12,000 for the current year, then you may claim deductions on the basis of USD 3,000 and have a carryover of USD 9,000. The following year, you can again claim a deduction on the basis of another USD 3,000, and carry forward the remainder amount. It must be noted that any sales with loss can become valid grounds for tax deductions, based on this concept.
Internal Revenue Service has included all these factors in their income tax return forms. Form 1040 Schedule D acts like a carryover worksheet where the loss can be reported. Line 16 of this schedule can be also used for the purpose of loss carryover to subsequent years, and Publication 523 can prove to be very helpful if you have any small queries regarding the matter. In addition, Topic 409 describes income tax rules regarding capital gains and losses.
There are, however, three merits of carryover, which are always pointed out when it comes to filing of income tax returns:
- Offset: Capital losses are used to cancel out capital gain. It basically means that if you incur a loss of USD 500, and at the same time, if you have a profit of USD 500, then these two quantities will cancel each other. The basic advantage is that the amount of income that is to be taxed reduces. Confused? Let’s take a better example. You have a loss of USD 500 and a profit of USD 1000. Put those two together and you will see that the USD 500 loss cancels out, bringing down the total profit to USD 500. Thus, your total profit that is taxed becomes USD 500. This feature holds true also for capital loss that has been carried down from the previous years.
- Income: The second merit is that the current capital loss, or the one that has been carried forward from previous years can be used to cancel out your income for that specific year. The current year’s income is thus reduced down, which eventually reduces tax liability.
- Carry Forward: Irrespective of any other economic condition, the carryover of capital loss is valid for tax deduction. This loss can be carried forward for a certain number of years and can be used in varying quantities for tax deductions. These quantities are however, not more than USD 3,000.
In short, this proves advantageous for any person or organization for tax deductions. Apart from this, there are numerous situations where it can be used to the benefit of the taxpayer.