Updated August 14, 2023
Definition of Capital Loss
Capital Loss is the loss arising from selling assets other than business inventory at a price less than the asset’s Book value. It is realized when the asset is sold or disposed of.
The loss realized can be set off against short-term or long-term capital gains depending upon the capital loss, whether short-term or long-term, based on the actual holding period and varies for different jurisdictions and asset classes. In short, the loss can be offset only against Capital Gain as against other Business Income.
Explanation
Sale of a Capital Asset below the purchase price results in a Capital Loss. It can take the form of a Short Term (if the holding period is less than three years) or a Long term ( if the holding period is more than three years). Also, when assessing the Purchase Price of a Capital asset, it is permissible to do indexation to account for the inflation over the period.
The period to differentiate between short-term and long-term capital losses varies and is not standard, as mentioned above. In some jurisdictions and certain capital assets, a short-term period refers to less than one year; above one year is categorized as Long Term. It depends from jurisdiction to jurisdiction. Further capital losses can be carried forward for a stipulated number of years and can be set off depending on the following:
- Short Term Capital Loss can be adjusted against both Short term gain as well as Long term gain.
- Long-term Capital Loss can be adjusted only against Long Term Capital gain.
The formula for Capital Loss:
The purchase price is accounted for inflation by indexing the same to adjust for the price inflation over the period.
How to Calculate Capital Loss?
It is computed using multiple steps, namely:
- Calculate the original acquisition cost of the Capital Asset and all capitalized expenses.
- Indexation of the Acquisition cost computed in the above step to the year of sale. This step is undertaken to account for inflation.
- We are determining the Sale Price of the Capital Assets after deducting all expenses incidental to the sale of the Assets.
- Subtracting the Sale Price from the Net Acquisition cost after indexation. A negative figure implies Capital Losses.
This standard methodology adopted for the computation of Capital Loss may vary in the case of a particular class of capital Assets. Also, in the case of Financial Instruments such as Bonds, Equities the concept of indexation is not to be applied, and it is directly computed after adjusting for Acquisition Cost.
Examples of Capital Loss
Let’s understand with the help of a few practical examples.
Example #1
Ryan purchased 1000 shares of Apple Inc in 2014 when the price per share was $12 and incurred a $1 per share in the form of brokerage. He decided to sell these shares in 2019 when the price of shares had fallen to $10 due to some medical emergency at his home and incurred a $0.5 per share in the form of the brokerage on the sale of such shares. Based on the same Capital Loss is shown below:
Acquisition Cost in 2014
| Number of shares purchased in 2014 (a) | 1000 |
| Purchase Price per share (b) | $12 |
| Brokerage Cost incurred per share (c) | $1 |
| Total Acquisition cost per share (d) = (c) +(b) | $13 |
| The total Acquisition cost of 1000 shares (e) = (d) * (a) | $13,000 |
Sale consideration in 2019
| Sale Price Per share (a) | $10 |
| Brokerage cost incurred per share (b) | $0.50 |
| Net Sale consideration received per share (c) = (a) – (b) | $9.50 |
| No. of shares sold (d) | 1000 |
| Total Sale Consideration received (e) = (d) * (c) | $9,500.00 |
| Capital Loss ($9,500.00 – $13,000 ) | $3,500.00 |
Example #2
ABC Limited purchased a Land parcel in 2013 and developed a building. The land cost at that time was $100000, and ABC Limited incurred $40000 in the development of the Building. In 2019 ABC Limited sold the piece of land along with the Building at a combined cost of $170000.Based on the same, compute the capital losses.
The Indexation of 2013-14 is 142, and 2019-20 is 187.
Acquisition Cost in 2013
| Cost of Land (a) | $100,000 |
| Building Development Cost (b) | $40,000 |
| Total Acquisition cost including Building Development (c) = (b) + (a) | $140,000 |
| Indexation in 2013-14 (d) | 142 |
| Indexation in 2019-20 (e) | 187 |
| Indexed Cost of Acquisition in 2019-20 for Capital gain/loss computation (f) = (c) * [(e) / (d)] | $184,366 |
Sale consideration in 2019
| Sale Price Received (a) | $170,000 |
| Brokerage and Processing Charge (b) | $0 |
| Net sale consideration received (c) = (b) * (a) | $170,000 |
| Capital Loss ($184,366 – $170,000) | $14,366 |
Importance
It is essential as it is a permissible item in tax computation, and businesses can adjust it against Capital gain, thereby reducing their total tax liability.
Advantages
Some of the significant advantages are mentioned below:
- It can be set off against capital gain, which can help reduce tax liability.
- It can be carried forward for many years, which varies for different countries. Usually, the period is eight years which means that the loss can be recovered against a capital gain in the future.
Conclusion
It is a common aspect found in the sale of capital assets. It happens when the consideration received on selling such assets is less than the acquisition cost, resulting in capital loss. Unlike business loss, it cannot be directly adjusted from Business Income. It can be changed only from capital gain (short-term or long-term, depending upon the type of capital losses). It can be carried forward for several years, which varies from jurisdiction to jurisdiction as per the prevalent income tax laws. Also, while calculating it, one must adjust the cost acquisition to account for indexation to realize the true capital gain or a capital loss. Despite the clarity, multiple challenges are involved in filing capital losses in income tax returns, and one needs to avail the services of a certified tax planner to assess capital losses correctly, following the income tax guidelines on capital gains and losses.
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