Investing insights
What are capital losses and how they work
9 min read
TL;DR: We often hear from people—including Frec customers!—who are confused about how capital losses work. If you only have thirty seconds, here’s our crash course:
- You generate a capital loss when you sell an asset (like a stock) for less than you bought it.
- Your capital losses can offset your capital gains to save on taxes. But there are some nuances.
- Once all gains are offset, you can also deduct up to $3,000 from your ordinary income each year.
- Capital losses never expire on the federal level. More on the state level in the essay below.
If you have a bit more time, read on, because understanding the nuances of capital losses can help you make better decisions and may help keep more of your own money.
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Consider three people in very different situations:
- Amy bought her first home a long time ago for $200k and now wants to sell it for $1M.
- Daragh joined Stripe early and would like to sell $3M in shares in a tender offer.
- Gopal wants to rebalance his portfolio, and in doing so will sell some index funds at a gain.
Capital losses are the thing that could help each of these people keep more of their money.
On paper, capital losses sound like one of the simplest financial concepts ever: a way to partially or completely offset your capital gains, saving you money on taxes.
In many ways, losses are indeed that simple. In other ways, they are not. And one realization we’ve had recently at Frec is that many people do not understand how capital losses really work. Some of these misconceptions are rather harmless, but others could be costing people huge amounts of their own money.
Just weeks ago, a customer let us know that they were moving their assets off of Frec because we had generated “too many” short-term capital losses for them. This person believed that the losses were not going to be useful to them. This wasn’t true, so we explained how short-term and long-term losses can be used, and the customer decided to stay with Frec. When our CEO posted about this on LinkedIn, we heard from a number of people that they, too, did not fully understand capital losses and would like to learn more.
The below is a Capital Losses 101 of sorts. By the end, you should know everything you reasonably need to know about capital losses as it pertains to your own finances.
Why this should matter to you
Not understanding capital losses could cause you to end up paying much more in taxes than you otherwise would have. And it could stop you from making important decisions, like selling a house or rebalancing your investments, because you have misconceptions about what the tax bill is going to be. The reverse is true, too: a good grasp on the basics of capital losses can help you make smarter decisions and keep more of your money.
The two types of capital gains and losses
You generate a capital loss by selling an asset for less than you bought it for. When you sell, your loss will fall into one of two categories: long-term or short-term. The criteria used here is the same criteria used when you sell an asset for a gain, which is relevant for how your losses can offset your gains.
The criteria for long-term and short-term losses (and gains) are as follows:
- Long-term: More than 12 months.
- Short-term: 12 months or less.
If you bought AAPL in 2018 and sold it in 2025, that’s a long-term trade. If you bought AAPL in January 2025 and sold it in April 2025, that’s a short-term trade. If you made money, that’s a gain, and if you lost money, that’s a loss. It really is as simple as that.
Of course, the average investor aims to avoid generating capital losses, since “selling an asset for a loss” is often equivalent to losing money. But understanding capital losses becomes more important if you are, like many Frec customers, generating more capital losses than usual via a process called tax-loss harvesting.
There is a lot to say about tax-loss harvesting, but in short it is an approach to investing that maximizes your losses when possible while continuing to target your long-term returns. You might, for example, sell a losing position and then immediately buy a similar (but not identical) investment—therefore maintaining your exposure while also generating a loss.
Most people who use Frec use tax loss harvesting to generate losses, and thus many have saved tens of thousands of dollars, via a process called direct indexing. You can learn more about direct indexing here.
So now you know the difference between long-term and short-term transactions. And you may be wondering: how does this actually play out when I want to offset a gain? Let’s walk through it.
How capital losses offset capital gains
To summarize, all capital losses can offset all capital gains and losses do not expire for life.
But there are some nuances to how you can actually use your losses. The rules:
- Like offsets like first: long-term offsets long-term, and short-term offsets short-term.
- Then, any losses left over (short-term or long-term) can offset any other capital gains.
- If you have offset all capital gains, you can then deduct $3k against your ordinary income each year—or $1,500 each if you are a married couple filing separately.
- Whatever you don’t use can be used for future gains. Losses do not expire for life.
If any of that feels confusing, remember the first sentence of this section: all capital losses can offset all gains and losses do not expire. The bullet points above explain the specifics of using your losses, which is helpful to know and useful for filing your taxes, but the bottom line is that your losses offset your capital gains and can even be used to deduct some of your ordinary income.
In other words, losses can be quite valuable!
Simulating this in a sample portfolio
Let’s look at a reasonable example. Say you sign up to Frec today with $250,000 so you can start direct indexing (i.e. so you can track, for instance, the S&P 500 while also accruing capital losses).
In Year 1 with Frec, we generate for you $4,000 in short-term losses and $11,000 in long-term losses. During that year, you also decide to sell some other stocks you have for a $10,000 long-term gain.
Here is how you would make your capital losses useful:
- Long-term: (Your $11,000 in losses) – (your $10,000 in gains) = $1,000.00
- Short-term: (Your $4,000 in losses) – (your $0 in gains) = $4,000.00
So you’ve offset all of your gains from the year (great!) and you still have $5,000 left over:
- $4,000 of that in short-term losses remaining
- $1,000 in long-term losses remaining
Now you can use the $3,000 deduction against your ordinary income. This comes first out of short-term losses, then out of long-term losses (if applicable). So, in this case, you would use $3,000 from your short-term losses against your ordinary income. And you’d end up with $1,000 in long-term gains and $1,000 in short-term gains to carry over to future years.**
*Note: Losses maintain their character (i.e. short-term or long-term) when they carry forward. In the example above, you would be carrying forward the remaining $1,000 in short-term losses and $1,000 in long-term losses to the future.
Yes, it is a lot of vocab: long-term, short-term, gains, losses, offset, deduct. But ultimately, capital losses at the federal level are rather simple, and if you made it this far, you probably have a more solid grasp of them now.
Capital losses might be treated differently in your state
So far, we’ve covered how capital losses are treated at the federal level. This is arguably the most important set of rules to understand, because (i) they apply to everyone in the United States and (ii) many states use the same, or a very similar, set of rules. Not all states follow along, though1.
New Jersey, for example, does not allow you to carry over your capital losses from prior years. Alabama doesn’t either, but it also does not impose the $3,000 limit on deducting capital losses from ordinary income. And Washington does not allow you to offset long-term gains with short-term losses because it typically ignores short-term capital gains and losses entirely.
If you pay an accountant (or other kind of tax help), they should know the rules in your state and should be able to sort this out. If you file on your own, you should do thorough research on your state’s tax code to check whether or not the federal rules apply to capital losses.
Start harvesting losses today with Frec
Generating capital losses is one of the best ways to reduce your tax bill when you realize a capital gain (like liquidating equity that’s gone up in value or selling a property you own). One of the smartest ways to do this is via a process called tax-loss harvesting, and in particular an approach called direct indexing.
The idea is fairly simple: instead of buying an ETF, you own individual stocks that track an index. Then Frec uses intelligent tax-loss harvesting to accrue losses while still tracking the index’s performance. From there, you can use the losses that Frec accrues to do everything we’ve described in this essay—which could save you many thousands of dollars.
If you’d like to learn more, you can schedule a call with our team or explore our live demo account.
FAQs about capital losses
What are capital losses?
You generate a capital loss when you sell an asset (like a stock, or a property) at a lower price than you purchased it for. You can then use these capital losses to offset capital gains.
Do capital losses expire?
Capital losses do not expire for life. (When you die, they do expire.)
What is a wash sale and how is it relevant to capital losses?
A ‘wash sale’ is the term for when you sell a security (like a stock) at a loss and then buy the same, or a “substantially identical”, security within 30 days before or after the sale. If you generate a capital loss via a wash sale, you cannot use it immediately. Instead, the loss is postponed until you sell the replacement security (assuming that selling the replacement security does not also trigger a wash sale). The wash sale rule exists to prevent abusing the rules around capital losses.
Can I still use capital losses if I’m subject to AMT?
Yes. If you are subject to Alternative Minimum Tax (AMT), you can still use capital losses in the way we describe in this essay. Both the regular tax system and AMT use generally the same rules for capital losses.
What are the limits on offsetting income with capital losses?
If you still have losses left over after offsetting all of your short-term and long-term capital gains for a year, you can use those losses to deduct up to $3,000 from your ordinary income—or $1,500 each if you are married and filing separately. Any losses left over after the $3,000 deduction carry over to following years.
