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Annette Nellen
Is It Time to Increase the Capital Loss Limitation?

With investors today sustaining losses upon disposition of capital assets, the question arises (again) as to whether the $3,000 capital loss limitation should be raised.

March 26, 2009
by Annette Nellen, CPA/Esq.

This article was originally published in the AICPA Tax Insider.

Non-corporate taxpayers may apply up to $3,000 of net capital losses against ordinary income each year. This rule (IRC §1211) has been set at $3,000 since 1978. Estimates are that the inflation-adjusted amount today would be about $8,000. Is it time to update this 30-year-old figure? In the past 30 years, there have been many changes to the capital asset provisions particularly with respect to tax rates. This article reviews proposals to raise the $3,000 limitation, the pros and cons of doing so, as well as alternatives.

History

The treatment of capital gains and losses is probably the most frequently changed area of the tax law. Since 1913, there have been a variety of loss limitations, gain deductions, holding periods, rates and definitions. In the first few years of our modern income tax, capital losses were not allowed unless associated with a business. The Revenue Act of 1918 allowed a net capital loss to be deductible. The current loss limitation dates back to the Tax Reform Act of 1976.

For a detailed history of the treatment of capital gains and losses, see Congressional Research Service, Individual Capital Gains Income: Legislative History (PDF), May 2006.

Proposals

Part of the tax plan Senator McCain promoted while campaigning in 2008 was to temporarily increase the capital loss limitation from $3,000 to $15,000 (“McCain Unveils New Economic Proposals,” The New York Times, October 2008). This isn’t the first time such a proposal has been suggested. In 2002, the House Ways & Means Committee even voted to increase the limitation (H.R. 1619). Following is a sampling of recent proposals.

  • H.R. 4661 (110th Congress): Increase the limit to $10,000 and adjust the amount annually for inflation.
  • H.R. 7123 (110th Congress): Increase the limit to $20,000.
  • H.R. 572 (108th Congress) and H.R. 1619 (107th Congress): Increase the limit to $8,250 and adjust it annually for inflation. In October 2002, H.R. 1619 passed in the House Ways & Means
    Committee (24-11).

Considerations in Critiquing Capital Asset Proposals

The longstanding use of varying schemes for subjecting capital gains and losses to the income tax indicates either that there is no single appropriate taxation method or that we do not want to use the appropriate method. The answer is a mix of these two possibilities. A broad measure of income would consider the change in value of capital assets during the year and tax all types of income similarly. Several problems exist with this approach including valuation and recordkeeping. Taxing all income similarly and only upon realization ignores the effects of inflation on capital assets (although the taxpayer has some benefit from the deferral of tax). Such treatment also ignores the effect of bunching of appreciation into a single year that might push the taxpayer into a higher tax bracket. These concerns have led to preferential rates for capital gains. Capital losses pose concerns of “gaming” the system. When gains are only taxed when realized, without a loss limitation, taxpayers could utilize losses even though they hold appreciated capital assets. Since gains escape income taxation if held at date of death — if losses were fully usable against any income — there would be reduced incentive to generate gains to offset losses. The Treasury Department's 1977 Blueprints for Basic Tax Reform, which suggested adoption of a comprehensive income tax that included inflation adjustments for capital gains, noted that “some asymmetry in the treatment of gains relative to losses would remain, because taxpayers could benefit by holding gains to defer taxes but could always take tax-reducing losses immediately.”

Arguments for a Higher Loss Limitation

Relief for market downturn: A higher loss limitation has been suggested as a way to help investors and the market in a downturn. Following the Ways & Means Committee’s favorable vote in 2002 to raise the loss limitation, Chairman Thomas noted that the change would “provide some tax relief to the millions of taxpayers who recently lost money in the stock market” (No. FC 29-A, October 2002). Congressman Mark Steven Kirk, R-IL, sponsor of H.R. 7123 (110th Congress), stated: “We must bring relief to middle-class families, while boosting investor confidence in an uncertain stock market.” (Cong. Rec. September 2008; E2096)

Effects of inflation: Per House Report No. 107-734 (PDF): “There has been significant inflation since [the] limit was enacted, and taxpayers who have capital losses that are not offset by capital gains should be able to deduct a greater amount against ordinary income.”

Taxpayers without unrealized capital gains: A key argument for a capital loss limitation is the ability of taxpayers to realize losses while holding appreciated capital assets. This argument though does not support a limitation for individuals who have little or no capital assets. Such individuals are disadvantaged due to the time value of money if it takes many years to utilize their capital loss carryforward.

Arguments Against a Higher Loss Limitation

Rate differential: The current asymmetry in the system includes the rate structure for capital gains and losses. While taxpayers today have a 15 percent rate for capital gains, the $3,000 of capital losses usable against ordinary income could result in a 35 percent tax savings. The larger the limitation, the greater the rate benefit.

Favors wealthy: Capital gains are skewed towards higher income individuals. The Congressional Research Service reports that in 2006, individuals with AGI (Adjusted Gross Income) above $200,000 (3% of taxpayers) reported 91 percent of the Schedule D capital gains (CRS, An Analysis of the Tax Treatment of Capital Losses, October 2008). A 2002 report estimated that over 50 percent of the tax benefit of doubling the loss limitation in 2003 would have gone to individuals with income over $100,000 (Gale and Orszag, A New Round of Tax Cuts? (PDF), 2002).

Subsidizes risk: Investments involve risk. A larger loss limitation inappropriately uses the tax system to subsidize and encourage some of that investor risk.

Cost: The estimated loss for H.R. 1619 (see above) was $9.9 billion over the first five years and $23.9 billion over 10 years (H. Rpt. 107-734 (PDF))

Alternatives

The gaming and distributional concerns over a larger loss limitation and the uncertainty as to whether an increase would or should help the market, weakens the policy arguments for permanently increasing the loss limitation for all taxpayers. Listed below are some alternatives that may be a compromise for those on both sides of the debate. Some of these proposals might be combined.

  • Temporarily increase the loss limitation as part of an economic stimulus plan. Some taxpayers may not have sufficient capital to restore losses and the carryforward may take many years to use. A problem with a temporary increase though is that taxpayers will want to make it permanent.
  • Allow for a larger loss limitation for individuals with AGI below a specified level.
  • Increase the limitation but restrict the tax benefit to the top capital-gains tax rate (rather than the higher ordinary income-tax rate). Similar approaches were used in 1924 (tax credit for losses) and 1969 (50% loss limitation) (CRS, An Analysis of the Tax Treatment of Capital Losses (PDF), 2002).

Conclusion

While an economic downturn and increased capital losses may seem like an appropriate time to increase a 30-year-old loss limitation figure, policymakers should proceed cautiously given the less than perfect design features in our current system for taxing capital gains and losses.

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Annette Nellen, CPA/Esq., is a tax professor and Director of the MST Program at San José State University. She is also a fellow with the New America Foundation. Nellen is an active member of the tax sections of the AICPA and ABA. She has several reports on federal and state tax reform and a blog.