site map

Barron's International Tax Service

« The TaxBarron » Serving the American Expatriate Community

Losses Are Not Always Capital

Mary Coombs from Florida likes to buy and sell stocks.  Having built up an investment portfolio of some $350,000, she probably fancies herself a trader even though her profession is marketing.  Most years she has between 50 and 75 stock sales to report on Schedule D of her US tax return.  Some of these sales are short term - less than a year from date of purchase - and some are long term - more than a year from purchase.  According to IRS, short term gains are netted against short term losses and long term gains against long term losses.

Investors benefit from taxation of capital gains versus ordinary gains.  Generally long term capital gains are taxed at 15% for taxpayers whose top ordinary income tax bracket exceeds 15%, or else 5% for those whose top bracket is either 10% or 15%.  Of course the property being sold must be classified as a capital asset to qualify for this lower tax treatment.  Capital assets include stocks, real estate used in trade or business, copyrights, and inventory and accounts receivable.  So as a stock trader, Mary pays lower taxes than she would pay on other taxable income.

In 2003 Mary had a bad year in which stock sale losses exceeded gains by $53,000.  After deducting an allowable $3,000 offset to other taxable income, she had a long term capital loss carry-forward of $50,000.  In 2004 she sold a rental property that she had owned outside the United States for nine years.  Because the property was situated in a South American country where economic conditions are unstable, she suffered a $20,000 loss on sale.

Although a resident in Europe since 1996, Mary also sold her Miami home in 2004 for a substantial $75,000 gain.  Later the same year, she bought another home in Europe for a purchase price which exceeded the Miami property's selling price.  Eager to preserve what she considered her capital loss carry-forwards in order to offset future stock sale gains, she was not expecting to have to recognize any gain on the sale of her Miami home.

When she discovered that her tax preparer had used up the $50,000 capital loss carry-forward against the Miami property gain on sale, Mary launched both barrels of her wrath.  She reminded him that she should be tax exempt up to $200,000 from the home sale.  Furthermore, 'there should be no reason to use those capital losses because I bought another house with all the Miami sale proceeds.  Also I lost $90,000 on the sale of my South American property!'

Under prior law, gain recognition on the sale of principal residence could be postponed as long as the seller bought another property within two years for a purchase price at least equal to the sales price of the old property.  This tax law was superseded by the 1997 Tax Act.  Thereafter a lifetime exclusion of $250,000 ($500,000 for married couples) was made available on home sales as long as the property sold qualified as the principal residence for 2 of the 5 years prior to sale.  Had the Miami property qualified as Mary's principal residence, she could have benefited from this exclusion.  Consequently, in order to reduce the taxable gain on the Miami property sale, the $50,000 from her 2003 loss carry-forward had to be applied.

Mary was correct concerning the loss on her South American rental property.  However, $70,000 in depreciation taken in prior years had to be recovered, resulting in only the $20,000 loss being counted.  The sale of depreciable rental property must be reported on Form 4797.  Gains from such sales can be carried from Form 4797 to Schedule D but not losses.  Losses are reported directly on line 14 of Form 1040.

The $20,000 loss had no affect on Mary's taxes because she had no remaining taxable income after reductions from the $50,000 loss carry-forward, $22,000 in itemized deductions and her $3,100 exemption (75,000 - (50,000 + 22,000 + 3,100)).  Her salary was fully eliminated by the Foreign Earned Income Exclusion.  So not only was she unable to benefit from the $20,000 loss being reported on Form 1040 but the loss could never be counted as a capital loss carry-forward without being reported on Schedule D.

Had the Miami property been Mary's principal residence, she could have excluded the gain with her $250,000 exclusion, leaving a balance of $175,000 to be applied against future personal home sales.  In the event she sells a principal residence at a loss, she will not be able to report it on her tax return and will be unable to receive any add back benefit to her lifetime exclusion.