With the financial turmoil and the volatile stock market, many have proposed increasing the limit on capital losses that can be deducted against ordinary income (the loss limit). An individual who is actually earning money on his portfolio can achieve tax benefits by realizing losses and not gains (and can hold assets with gains until death when no tax will ever be paid). The assets in these plans are not affected by the net loss restrictions. Symmetrical treatment of long-term gains and losses, however, would allow only 50% of a net long-term loss to be deducted against net short-term gains ($100 of net long-term loss could only offset $50 of net short-term gain). It established the current law treatment of gains by lowering the maximum tax rate on long-term capital gains income to 20% (and creating a 10% maximum capital gains tax rate for individuals in the 15% tax bracket). Under current law, asymmetries between the tax treatment of capital gains and losses remain. When capital gains income is taxed more lightly than other types of income, allowing capital losses to offset other income without limit increases a taxpayer's ability to minimize income taxes by altering the timing of the realization of gains and losses. In most cases, the current system, even without indexing the $3,000 loss for inflation, is more generous than the system that existed in 1978. In general, most of the capital losses are realized on assets that are predominantly owned by higher income taxpayers. Taxpayers with net capital losses can deduct up to $3,000 against ordinary income, but about 60% are subject to the loss limit and have to carryover the excess losses to subsequent years. One argument that might be made for providing capital gains tax relief is that it would increase the value of the stock market and thus investor confidence. Such a link is weaker and more uncertain than a direct stimulus to the economy via spending increases or cuts in taxes aimed at lower income individuals. Policy Options

Several reasons have been advanced to increase the net capital loss limit against ordinary income: as part of an economic stimulus plan, as a means of restoring confidence in the stock market, and to restore the value of the loss limitation to its 1978 level. In the short run, an increase in the loss limitation could produce an incentive to sell stock, which could depress stock prices and erode confidence even further. Furthermore, the empirical evidence suggests that the tax benefits of an increase in the net capital loss limitation would be received by a relatively small number of higher income individuals. Second, while correcting the $3,000 loss limit to reflect price changes since 1978 would increase its value to about $10,000 in 2010 dollars, net long-term capital losses are generally treated more preferentially than they were prior to 1978 because of the asymmetry between loss and gain, which was never addressed during recent tax changes. Restoration of historical treatment would also require an adjustment for asymmetry. Raising the limit on losses without addressing asymmetry will expand opportunities to game the system. If net short-term losses are less than the loss limitation, then $2 of net long-term loss can be used to offset each $1 remaining in the net loss limitation.
Several reasons have been advanced for increasing the net capital loss limit against ordinary income: as part of an economic stimulus plan, as a means of restoring confidence in the stock market, and to restore the value of the loss limitation to its 1978 level. Under current law, long-term and short-term losses are netted against their respective gains and then against each other, but if any net loss remains it can offset up to $3,000 of ordinary income each year. Capital loss limits are imposed because individuals who own stock directly decide when to realize gains and losses. The limit constrains individuals from reducing their taxes by realizing losses while holding assets with gains until death when taxes are avoided completely.
Current treatment of gains and losses exhibits an asymmetry because long-term gains are taxed at lower rates, but net long-term losses can offset income taxed at full rates. Individuals can game the system and minimize taxes by selectively realizing gains and losses, and for that reason the historical development of capital gains rules contains numerous instances of tax revisions directed at addressing asymmetry. The current asymmetry has grown as successive tax changes introduced increasingly favorable treatment of gains. Expansion of the loss limit would increase "gaming" opportunities. In most cases, this asymmetry makes current treatment more generous than it was in the past, although the capital loss limit has not increased since 1978.
Capital loss limit expansions, like capital gains tax benefits, would primarily favor higher income individuals who are more likely to hold stock. Most stock shares held by moderate income individuals are in retirement savings plans (such as pensions and individual retirement accounts) that are not affected by the loss limit. Statistics also suggest that only a tiny fraction of individuals in most income classes experience a loss and that the loss can usually be deducted relatively quickly.
One reason for proposing an increase in the loss limit is to stimulate the economy, by increasing the value of the stock market and investor confidence. Economic theory, however, suggests that the most certain method of stimulus is to increase spending directly or cut taxes of those with the highest marginal propensity to consume, generally lower income individuals. Expanding the capital loss limit is an indirect method, and is uncertain as well. Increased capital loss limits could reduce stock market values in the short run by encouraging individuals to sell.
Adjusting the limit to reflect inflation since 1978 would result in an increase in the dollar limit to about $10,000. However, most people are better off now than they would be if the $3,000 had been indexed for inflation if capital losses were excludable to the same extent as long-term capital gains were taxable. For higher income individuals, restoring symmetry would require using about $2 in long-term loss to offset each dollar of ordinary income. Fully symmetric treatment would also require the same adjustment when offsetting short-term gains with long-term losses. This report will be updated to reflect legislative developments.