Capital losses can have a major impact on a taxpayer's tax liability. Understanding how to determine which losses can be carried forward to a subsequent year is a crucial aspect of effective tax strategy.

When the net result on the Schedule D line 16 is a loss, the loss is limited to a maximum of $3,000 ($1,500 if married filing separately, including married individuals filing HH). Losses in excess of those limits can generally be carried forward to future years.

The question frequently arises whether or not an individual must file a return, even if not otherwise required to file, in order to preserve a capital loss carryover.

In reading the IRS instructions, it seems the answer is no based upon the following statement that appears in IRS Publications 550 (Pg. 66) 2021 version:

However, to claim a capital loss carryover the Schedule D instructions indicate the taxpayer needs a copy of their prior year 1040 and Schedule D to complete the capital loss worksheet to determine how much loss is carried forward from the prior year.

In figuring the carryover, the amount of the capital loss carryover is the amount of taxpayer’s total net loss that is more than the lesser of the taxpayer’s:

It appears there is no actual requirement to file a return where one is not otherwise required to be filed. However, since the carryover is based upon the results of a prior year return, the taxpayer would have to be able to reconstruct the prior year return to prove the carryover if challenged on the amount of the carryover.

According to the Tax Court, and referencing Reg. Sec. 1.6001-1(e), if a capital loss is to be carried forward from one year to another, the taxpayer must keep records substantiating (1) that the taxpayer incurred a loss, (2) that the taxpayer is entitled to deduct the loss, (3) the character of the loss, and (4) the amounts of any capital gain offset during any subsequent years. (Xing F. Wang and Kathleen P. Lee v. Commissioner, T.C. Memo. 2017-081, May 15, 2017) So, not only is it necessary to keep a copy of the tax return and the documentation of the transactions that created the loss (1099-B, purchase records, etc.) for the year the loss originated, the taxpayer will need these records for each year until the loss is used up (plus at least 3 years thereafter for the statute to run out).

Best Practice: We believe that the best practice may be to actually file a return and run the statute of limitations even though a return is not actually required.