What is an ordinary loss?
An ordinary loss is a loss realized by a taxpayer when expenses exceed income in normal business operations. Ordinary losses are losses incurred by a taxpayer that are not capital losses. An ordinary loss is fully deductible to offset income, thereby reducing the tax owed by a taxpayer.
Understanding Ordinary Loss
Ordinary losses can arise from many causes, including accidents and theft. When ordinary losses exceed a taxpayer’s gross income in a tax year, they become deductible. Capital and Ordinary are two tax rates applicable to specific asset sales and transactions. Tax rates are tied to the taxpayer’s income marginal tax rate. Net long-term capital rates are significantly lower than ordinary rates. Hence the conventional wisdom that taxpayers prefer capital rates on gains and ordinary rates on losses.
In 2022, the rates have graduated over seven tax brackets from 10% to 37% for the ordinary rates, and from 0% to 20% for the net long-term capital rates. In addition, taxpayers in the highest tax bracket must pay 3.8% Net Investment Income Tax (NIIT).
Key points to remember
- An ordinary loss is realized by a taxpayer when expenses exceed income in normal business operations.
- Ordinary losses are distinct from capital losses.
- An ordinary loss is fully deductible to offset income, thereby reducing the tax owed by a taxpayer.
- Capital losses occur when capital assets are sold for less than cost.
- Taxpayers are allowed to deduct up to a certain limit for capital losses, while there is no limit for ordinary losses.
Ordinary loss vs capital loss
An ordinary loss is a metaphorical wastebasket for any loss that is not classified as a capital loss. Realizing a capital loss occurs when you sell a capital asset, such as a stock investment or property you own for personal use, for less than its original cost. The recognition of an ordinary loss occurs when you sell goods such as inventory, supplies, trade receivables, real estate used as rental property, and intellectual property such as musical compositions, literature, software coding or artistic. It is the loss suffered by a business owner operating a business that does not make a profit because expenses exceed income. Loss recognized on property created or available as a result of a taxpayer’s personal efforts in carrying on a trade or business is an ordinary loss.
For example, you spend $110 to write a musical score that you sell for $100. You have an ordinary loss of $10.
Ordinary loss can also arise from other causes. Accident, theft and sales between related parties make an ordinary loss. The same goes for sales of Ownership of item 1231 such as real or depreciable property used in a trade or business that has been held for more than one year.
Ordinary losses for taxpayers
Taxpayers like their deductible loss to be ordinary. The ordinary loss, on the whole, offers greater tax savings than a long-term capital loss. An ordinary loss is generally fully deductible in the year of the loss, while a capital loss is not. An ordinary loss will offset ordinary income on an individual basis. A capital loss is strictly limited to offsetting a capital gain and up to $3,000 of ordinary income. The remaining capital loss must be carried forward to another year.
Let’s say that during the tax year you earned $100,000 and had $80,000 in expenses. You bought stocks and bonds and six months later sold the stocks for $2,000 more and the bonds for $1,000 less than you paid. Then the stock market crashed when you sold the stocks and bonds you bought over a year ago, so you sold the stocks for $14,000 less and the bonds for 3 $000 more than you paid. Let’s clean up your gains and losses to determine your overall gain or loss and whether it is ordinary or capital.
- Deduct your short-term capital gains and losses. $2,000 – $1,000 = $1,000 net short-term capital gain.
- Clean up your long-term capital gains and losses. $3,000 – $14,000 = $11,000 net long-term capital loss.
- Claim your net short-term and long-term capital gains and losses. $1,000 – $11,000 = $10,000 net long-term capital loss.
- Net your ordinary income and losses. $100,000 – $80,000 = ordinary gain of $20,000.
- Deduct your net ordinary and net capital gains and losses. $20,000 – $3,000 = ordinary gain of $17,000.
- Report the remaining net capital loss of $7,000 over the next three years.
How much ordinary loss can you claim on taxes?
An ordinary loss is fully deductible from taxable income. There is no limit to the amount that can be deducted.
Can you carry forward ordinary losses?
Ordinary losses are fully deductible in the year they are incurred and cannot be carried forward to subsequent years. Capital losses exceeding the maximum deductible amount can be carried forward to future years.
What is the difference between an ordinary loss and a capital loss?
A capital loss occurs when a capital asset is sold for less than it cost. For example, if equipment that cost $10,000 is sold for $8,000, a capital loss of $2,000 is incurred. An ordinary loss arises when business expenses exceed business income, when non-capital assets are sold, or for certain non-capital transactions.