No – under U.S. tax law, you generally cannot deduct an unrealized loss (a “paper” loss) until it becomes realized by a sale, exchange, or worthlessness event.
Imagine watching your portfolio dip 20% and wondering if Uncle Sam will share your pain. You’re not alone – over 60% of investors misunderstand whether they can write off losses on assets they haven’t sold. This guide will clear that confusion once and for all. It breaks down the rules for individuals, small businesses, and seasoned investors in plain English. By the end, you’ll know exactly why unrealized losses usually aren’t deductible and how to work within tax laws to make the most of genuine losses.
- 🚀 Fast Answer Upfront: The IRS won’t let you deduct a loss on an asset until you sell it or it’s truly worthless. (We’ll explore the rare exceptions and the logic behind this rule.)
- 🏢 Who It Impacts: Learn how this rule plays out for individual taxpayers vs. small business owners vs. active investors – each faces different considerations and pitfalls.
- 💡 Loopholes & Exceptions: Discover legal workarounds like mark-to-market accounting, Section 165 rules for worthless assets, and tax-loss harvesting strategies that turn paper losses into real tax benefits (when done right).
- 📊 Real-World Examples: We’ll walk through scenarios in stocks, crypto, real estate, and inventory with easy tables, so you can see exactly when a loss becomes deductible (and when it doesn’t).
- ⚖️ Avoiding Costly Mistakes: Find out the common tax traps (🚫 like wash sales and related-party sales) that can nullify your loss deduction, plus key IRS regs, court cases, and state tax nuances you should know.
Unrealized vs. Realized Losses: The Crucial Difference
Unrealized losses (also called “paper losses”) occur when an asset you own has dropped in value, but you still hold it. Realized losses occur when you actually sell or dispose of the asset for less than what you paid (your basis). This difference is crucial in tax law. The U.S. tax system generally follows the “realization principle,” meaning tax events happen only when a gain or loss is realized through a transaction.
For example, if you bought stock for $10,000 and it’s now worth $6,000, you have a $4,000 unrealized loss. On paper you’re down, but for tax purposes, nothing has happened yet. If you sell those shares for $6,000, that $4,000 loss becomes realized – only then can it potentially affect your taxes. Until a loss is realized, the IRS views any value change as hypothetical. After all, markets can rebound; an asset down 40% this year might recover or exceed its original value next year. Tax law waits for a clear, closed transaction.
Key point: A loss isn’t “sustained” in the eyes of the IRS until an identifiable event fixes that loss. In practice, this usually means a sale, exchange, or the asset becoming worthless. Without such an event, your loss is considered transient or reversible. This approach prevents endless debates about temporary market dips and ensures that deductions reflect actual economic losses.
Federal Tax Rules: Why You Can’t Deduct Paper Losses
Under federal law, the general rule (Internal Revenue Code Section 165) says you can deduct losses sustained during the taxable year that are not covered by insurance or other compensation. The catch is in the word “sustained.” A drop in value alone doesn’t count as “sustained” – there must be a realization event. The tax code and IRS regulations require a “closed and completed transaction” or a fixed, identifiable event to lock in the loss.
🔹 Capital Assets (Stocks, Bonds, Crypto): For investments like stocks or cryptocurrency (which the IRS treats as property), a sale or exchange is needed to realize a loss. Until you sell, any loss is not recognized for tax purposes. If your stock portfolio is down $10,000 but you haven’t sold anything, you can’t claim a $10,000 loss on your tax return. It doesn’t matter how much value evaporated on paper – no sale, no deduction.
🔹 Why the Rule Exists: The IRS disallows deductions for unsold losses to prevent abuse and practical issues. If we could claim deductions for paper losses, we’d also logically have to tax paper gains – something both taxpayers and the IRS want to avoid for fairness and simplicity. Moreover, valuations can fluctuate wildly. Taxing (or deducting) unrealized amounts could lead to whipsaw effects – imagine deducting a huge loss one year, then the asset recovers and you owe taxes on gains you never cashed out. By waiting for realization, the tax code aims to tax actual income and allow losses only once they’re final.
🔹 Section 165 in Action: Section 165 allows deductions for losses actually sustained in the year – typically meaning the asset was sold for less than basis, or was destroyed, stolen, or became worthless. The IRS has consistently held that a mere decline in value with no sale is not a sustained loss. There must be a transaction or an event such as worthlessness. In fact, tax regulations state that if no sale or identifiable event has occurred, the loss is not deductible in that year. This has been upheld in numerous court cases: courts deny deductions for “shrinkage in value” absent a sale. Even a Supreme Court decision from as far back as the 1940s required proof that stock became totally worthless in that year to claim a loss – no deduction just because the price plunged.
🔹 Capital Loss Limitations: When you do realize losses, there are limits. For individual taxpayers, net capital losses (the amount your losses exceed your gains) can be deducted against ordinary income only up to $3,000 per year ($1,500 if married filing separately). Any excess carries forward to future years. This means even once you’ve realized a large loss, you might not use it all at once if you have no gains – you’d deduct $3k per year and carry over the rest. (Businesses structured as C-corporations face an even stricter rule: they cannot deduct net capital losses against ordinary income at all – they can only use capital losses to offset capital gains. Corporate capital losses can be carried back 3 years or forward up to 5 years, but again, only to soak up capital gains in those years, not to reduce other income.)
🔹 Personal Use Assets: It’s worth noting that even a realized loss on personal-use property is usually not deductible. For example, if you sell your personal car or your primary home for less than you paid, that’s a realized loss – but the tax code specifically disallows deductions for losses on personal assets. The logic is that personal items (your car, furniture, personal residence, etc.) are not held for investment or business, so any loss on their sale is considered personal consumption, not a deductible investment loss. Many homeowners learn this the hard way: if you buy a house and later sell it at a loss, you cannot deduct that loss on your taxes (whereas if you sold at a gain, you might owe tax on the gain above certain exclusions). The IRS essentially says personal enjoyment and use come with risks of value changes that aren’t tax-deductible.
Bottom line: Under federal tax law, unrealized losses do not count. You must convert that paper loss into a realized one – usually by selling the asset or otherwise disposing of it – to even consider a deduction. And even then, various rules determine how and when you can actually use that loss on your return.
Individuals and Unrealized Losses
What does all this mean for everyday individual taxpayers? Most individuals encounter “unrealized loss” questions with their investment portfolios or personal property. Here’s how different situations play out:
- Stocks and Bonds: If you have stocks, ETFs, or mutual funds in a taxable account that dropped in value, you cannot deduct the decline unless you sell the shares. For instance, if your $50,000 investment in a fund is now worth $30,000, you have a $20k loss on paper. But on your tax return, that loss is invisible until you realize it. If you sell and lock in the $20k loss, it becomes a capital loss that can offset capital gains and possibly up to $3k of your other income (with the remainder carried forward). Until then, the IRS treats you as though nothing happened – your basis is still $50k, and no taxable event occurred.
- Cryptocurrency: The same principle applies to crypto like Bitcoin or Ethereum. Say you bought crypto for $10,000 and its market value is now $4,000. As long as you continue to HODL and not sell or trade it, that $6,000 loss is unrealized and not deductible. Crypto is considered property for tax purposes, so selling it would realize a capital loss. (One quirk: as of now, crypto is not subject to the wash-sale rule because it’s not classified as a security. We’ll discuss this in the strategies section – it means savvy investors can sell crypto at a loss for a deduction and buy it back immediately without penalty. But again, they must sell to get the loss; just holding the bag as it drops gives no tax benefit.)
- Personal Assets: For individuals, remember that losses on personal-use property are not deductible at all. So if your car’s value plummets, or you sell your personal jewelry or electronics for less than you paid, no deduction. This often surprises people because it feels like “I lost money, why can’t I deduct it?” The IRS’s stance: those items weren’t investments or business assets – they were for personal use, so the loss is personal too. Even a personal home sale at a loss is nondeductible. By contrast, if you have investments in collectibles (like rare coins or art) or investment real estate, losses there could be deductible when realized, because those are held for profit. The key is the intent and use of the asset.
- Capital Loss Usage: When individuals do realize capital losses (say by selling stocks or crypto at a loss), they can offset any capital gains first. If losses exceed gains, up to $3,000 of the excess can reduce other income each year. This $3k rule is a nice perk for individual filers (married couples get $3k total, not double). For example, if in 2025 you have $10,000 in realized capital losses and no gains, you can use $3,000 of that to reduce your wage or other income on your 2025 tax return, and carry the remaining $7,000 forward to 2026 and beyond. The carried-forward losses retain their character and can again offset gains or give you another $3k deduction each year until used up. It’s a tax consolation prize for your investing misfortunes. (Be aware: if you’re filing state taxes, some states follow the same $3k rule, while others might handle capital loss offsets differently or not allow a deduction against ordinary income at all – more on state nuances later.)
- Wash Sale Trap: Individual investors must also be careful about the wash-sale rule. This rule prevents a common mistake: selling a stock at a loss to claim the deduction, and then quickly buying the same stock back. If you buy the same or a “substantially identical” security within 30 days before or after selling it for a loss, the IRS disallows the loss deduction. It’s as if the sale never happened for tax-loss purposes. The loss isn’t gone forever – it’s added to the cost basis of the new shares – but you don’t get the immediate deduction. Example: You sell 100 shares of XYZ stock on December 1 for a loss, then on December 20 you repurchase 100 shares of XYZ. Because you repurchased within 30 days, the $5,000 loss you realized on Dec 1 is not deductible in 2023. Instead, that $5,000 is added to the basis of the new shares. The wash sale rule basically says “no cheating – you can’t sell just to get a tax break and then rebuy right away.” So, if you plan to harvest a loss, make sure you (or even your spouse or a company you control) don’t buy the same stock for at least 30 days after the sale (and also didn’t buy shortly before the sale). This rule currently does NOT apply to crypto or other assets like commodities, only stocks, bonds, mutual funds, and options on securities. But be cautious: proposals have been floated to extend the wash sale rule to crypto, so always stay updated on law changes.
- Related-Party Sales: Another pitfall: selling assets at a loss to a related party. Under tax code Section 267, losses from sales between certain related persons are disallowed. For example, you can’t sell stock at a loss to your spouse, or to your controlled company, or even to a sibling or parent in some cases, and then claim that loss. The IRS disallows it on the premise that it wasn’t an arm’s-length transaction – you and your relative as a unit haven’t truly incurred a loss economically (it’s just moved within the family). So, if you’re thinking of realizing a loss by selling an asset to a family member who’s happy to buy it, don’t expect a tax deduction from that. It’s a common mistake to avoid.
Summary for individuals: Unrealized losses in your investment accounts won’t help your taxes at all – you must realize losses through sales (or other qualifying events) to get a deduction. Even then, be mindful of the $3k annual limit and special rules like wash sales and related-party disallowance. And remember, losses on personal-use items are simply not tax-deductible. Focus your tax planning on assets held for investment or business if you’re looking to harvest losses.
Small Businesses and Unrealized Losses
Small business owners face the same fundamental rule: an unrealized decline in value is not immediately deductible. However, businesses encounter unrealized losses in different forms – like unsold inventory that’s worth less, depreciating equipment, or bad debts that might not be paid. Let’s break down key areas:
- Inventory Value Drops: If you have a business that carries inventory (products for sale), you might find that some stock on your shelves is no longer worth what you paid – perhaps due to obsolescence, spoilage, or market price declines. For financial accounting (GAAP), businesses often write down inventory to the “lower of cost or market (net realizable value)” to reflect reality. But for tax purposes, you can’t just freely write down inventory value to create a deduction unless you meet strict IRS rules. The IRS generally requires inventory to be valued consistently each year under an approved method. Tax regulations allow inventory write-downs only if market value truly falls below cost and even then under specific conditions (e.g. goods are offered for sale below cost or are unsalable/damaged). If you think, “I’ll write my inventory down to its scrap value and deduct the loss,” be careful – the IRS expects objective evidence (like actual sales of similar stock at markdown prices or the items being scrapped). Example: You run an electronics shop with $50,000 of inventory that’s gone obsolete, now realistically worth $20,000. Can you take a $30,000 deduction for the lost value this year? Not automatically. For tax, if you continue to hold the inventory, you generally can’t claim a loss until you actually dispose of it (sell it at a discount, liquidate, or prove it’s worthless). If your accounting books write it down, that’s fine for GAAP, but your tax return might ignore that until an event happens. (In one famous Supreme Court case, Thor Power Tool Co. (1979), a company wrote down a bunch of “excess” inventory to scrap value on its financials. The IRS disallowed the deduction for tax because the items were still on hand for sale and the write-down didn’t meet IRS rules. The Court upheld the IRS, emphasizing that GAAP’s conservative accounting doesn’t trump tax law’s requirement of realized loss or clear evidence of decline. They noted the company’s plight of carrying obsolete stock, but called it “the dilemma every taxpayer with a paper loss must face” – you typically have to wait until the loss is confirmed by sale or scrap.) The lesson: for tax deductions, you usually must actually scrap the inventory or sell it at a loss before claiming a loss. If you do physically dispose of worthless inventory or sell products below cost to clear them out, then yes, those losses become realized (often reflected through Cost of Goods Sold or as an ordinary loss if you scrap them). Many small businesses get to deduct stale inventory eventually, but at the point of disposition, not just from a revaluation exercise.
- Depreciating Equipment and Assets: Businesses invest in assets like machinery, vehicles, computers, or even real estate for business use. These often lose value over time through wear and tear or market changes. Tax law handles this with depreciation deductions over the asset’s useful life, not by letting you claim sudden market value drops. If your $100,000 piece of equipment is now worth $60,000 in the used market, that $40k drop isn’t immediately deductible just because of market value. You continue to depreciate it as per schedule. Only if you dispose of the asset – sell it, trade it, or abandon it – do you realize any remaining loss (basis minus any sale price). For instance, if the machine still has $70k of tax basis left and you sell it for $60k, you’d get a $10k loss deduction at that time. Or if it’s truly worthless to your business and you throw it out (abandon it), you could potentially deduct the remaining basis as a loss (abandonment loss). Important: If you simply keep an asset that’s dropped in value, you can’t write it down to market on your tax return. This is a key difference from accounting versus tax – accounting standards might require an impairment write-down on long-lived assets if their value is impaired. But tax law says nope, you keep depreciating on the original cost basis, unless and until you scrap or sell the asset. There are a few exceptions: for example, certain financial instruments or inventory (as discussed) and some specialized asset mark-to-market rules.
- Bad Debts (Accounts Receivable): If your business is owed money that you’re not going to collect (a customer that defaulted or a client who never paid), that’s an economic loss. Under Section 166 (Bad Debt Deduction), businesses can deduct debts that become worthless during the year. Here, there is a bit of flexibility: a business can often take a deduction for a partially worthless debt as well, if you can demonstrate part of it won’t be collected. This is somewhat akin to recognizing an “unrealized” loss (since you haven’t gotten a payment you expected). But the IRS will want to see proof – e.g. you exhausted collection efforts, the debtor is insolvent, etc. For non-business bad debts (like a personal loan to a friend that went bad), individuals can only deduct it when it’s completely worthless, and then it’s treated as a short-term capital loss. So for a business, writing off a bad receivable is essentially realizing the loss of that expected income. You can’t deduct a mere doubt about collectability; you need reasonable evidence the debt won’t be paid. Once you have that, the debt can be written off and deducted (which is effectively the “event” that realizes the loss of that receivable’s value).
- Small Business Stock Losses: If you as an individual invested in a small business (say you bought shares in a startup), those shares are a capital asset to you. A loss on them isn’t deductible until realized (same rules). But there’s a special provision: Section 1244 stock. If you bought qualified small business stock (Section 1244 stock) and it becomes worthless or you sell at a loss, you might deduct some of that loss as an ordinary loss (up to $50,000, or $100k if married) instead of a capital loss. This is a nice exception because ordinary losses are fully deductible against income without the $3k cap. However, Section 1244 doesn’t let you deduct anything while the stock is just down in value – it must be sold or worthless. It just changes the character of the loss once realized. I mention this to show that even special rules for small businesses still require realization – they just tweak how the loss is treated after realization.
- GAAP vs Tax Accounting: Many small businesses keep books in accordance with GAAP (Generally Accepted Accounting Principles) or another framework, which might record unrealized losses for transparency. For example, you might mark down inventory or record an impairment of an asset on your financial statements to inform investors or lenders of true value. However, tax accounting is a separate animal. The IRS isn’t interested in hypothetical or estimated losses – only actual transactions. It’s common for a business’s financial statement to show a big loss for depreciation or write-downs while the tax return shows a different number because some of those losses aren’t tax-deductible (yet). The Financial Accounting Standards Board (FASB), which sets GAAP, aims to reflect economic reality for stakeholders, so it allows recognizing certain unrealized losses (like marketable securities categorized as “trading” securities hit earnings with unrealized losses, or writing down impaired goodwill). The IRS, on the other hand, has statutes and regs to enforce, often sticking to the realization concept. So don’t assume that just because an expense or loss shows up on your profit-and-loss statement, it will be allowed on the tax return. A classic small biz example: goodwill impairment. If you bought another business, part of what you paid may be booked as goodwill. If that goodwill later is deemed worthless and impaired under GAAP, you write it off in the books. For tax, goodwill is amortized on a fixed schedule (15 years if after 1993 acquisition) – you generally can’t accelerate a deduction just because it’s impaired, unless you actually dispose of or abandon the business/unit associated with it. In essence, tax law often lags behind economics, intentionally.
- Capital Losses in a Business: If a small business (say a corporation or an LLC taxed as one) invests in stocks or other capital assets, the same capital loss rules apply. One notable difference: a C-Corp that has a capital loss can’t use it against ordinary income at all (unlike individuals who get a little $3k). The corp would have to carry it to other years where it has capital gains. Many small businesses are pass-through entities (S-Corps, partnerships, LLCs) where the gains and losses flow to the owners’ personal returns; in those cases, the individual rules (with $3k limit, etc.) apply at the owner level. It’s good to be aware of these limitations when planning business investments.
In summary, a small business cannot simply deduct losses because assets or inventory have declined in value. The business must actually realize the loss by selling inventory at a discount, scrapping unused materials, disposing of assets, or writing off bad debts, etc. Deductions follow real economic losses, not anticipated ones. Business owners should be mindful of the distinction between financial reporting and tax reporting. The IRS may let you take the deduction eventually, but usually not until you’ve taken concrete action that seals the loss.
Investors and Traders: Special Rules and Elections
Now let’s talk about those who are in the business of investing or trading – active investors, traders, and certain financial professionals. While the core rule (no deduction for unrealized losses) still holds, there are special tax provisions that effectively let or force some taxpayers to treat unrealized gains and losses as realized each year. These are advanced strategies or rules that typical individual investors don’t encounter, but they’re crucial for high-volume traders and some investment entities:
- Mark-to-Market Election (Section 475(f)): This is a game-changer for qualified traders. If you are a full-time trader who meets the IRS criteria for “trader in securities or commodities” (meaning you’re not just investing for long-term, but actively trading as a business), you can elect mark-to-market accounting for your trading portfolio. By making a Section 475(f) election with the IRS, you agree to treat all your trading positions as if they were sold at fair market value on the last day of each tax year. In other words, you mark your holdings to market prices on Dec 31, and you report those gains or losses as if you sold everything. Then Jan 1 of the new year, you pretend you bought them back at that market value (the slate resets). This means unrealized losses become realized and deductible each year (and unrealized gains become taxable each year). Why would anyone do this? A few reasons:
- If you have significant trading losses, marking to market lets you deduct those losses as ordinary losses, without the $3k cap. With a valid 475 election, your trading losses aren’t subject to capital loss limits or wash sale disallowances. They’re treated as ordinary business losses, so you can use them to offset other income in full. This is huge if you have a bad year.
- It also simplifies record-keeping in a way – you don’t have to track carryover lots or wash sales because each year stands on its own.
- However, it’s a two-edged sword: in good years, all gains are taxable immediately (no deferring by holding assets), and they’re generally taxed as ordinary income (no special long-term capital gains rates, since everything is treated like inventory of a dealer). Also, making the election is a commitment – you usually have to stick with it for future years unless you get IRS permission to change. So you wouldn’t elect it lightly.
- Example: Jane is a day trader who qualifies for trader tax status. In 2025, her trading account went from $500k to $300k due to many losing trades – an unrealized drop of $200k by year-end. If she had the mark-to-market election in place, she can deduct that $200k loss on her 2025 return as an ordinary loss (which could offset, say, other income or be carried back/forward if a net operating loss). She doesn’t have to worry about the $3,000 limit. If she didn’t have the election, she’d only be able to deduct her realized losses (say she sold some positions) and carry over the rest, possibly taking years to fully deduct. On the flip side, if her account had grown, mark-to-market would make her pay tax on open positions as if sold – which traders accept in exchange for the benefits.
- In short, Section 475(f) is an elective way to circumvent the normal “no unrealized losses” rule by choosing to realize everything on paper annually. It effectively converts unrealized to realized on Dec 31. The IRS allows this for traders because their business is buying/selling securities – it aligns with how dealers in securities must mark their inventory (dealers are required to under Section 475(a)). If you think you qualify as a trader and want this, note that the election has to be made by the tax return due date (ex: for 2024, you must file an election statement by April 15, 2024). Consult a tax advisor because the rules to qualify as a trader are quite specific (high volume, short holding periods, intent to profit from short-term swings, etc.).
- Section 1256 Mark-to-Market (Mandatory): Separately from Section 475, certain types of financial contracts are automatically marked to market by law at year-end. Section 1256 contracts include things like regulated futures contracts, certain index options, broad-based index options, foreign currency contracts, etc. If you trade futures or forex, for example, each open position at year-end is treated as sold at market price on Dec 31. Gains or losses are recognized (60% long-term, 40% short-term by a special rule). So in this case, unrealized losses on these contracts are effectively deductible each year because the law deems them realized. You don’t have a choice here – it’s required. This primarily affects active investors in commodities or certain options. For the average stock or crypto investor, Section 1256 doesn’t apply; it’s more for specialized traders or funds.
- Professional Funds and Valuation: Some investment funds (like mutual funds, hedge funds) might report to their investors and mark to market internally, but for tax purposes, the investors typically only recognize gains/losses when distributions are made or shares sold, etc. One thing to mention: mutual funds (RICs) can pass through capital gains and losses to shareholders. But if a mutual fund has an unrealized loss in its holdings, it can’t pass that to you until it sells those holdings. It may retain some losses to offset its own gains. Closed-end funds or ETFs might have market price swings but your tax is based on realized events (sales inside the fund or when you sell your shares). So even in managed investments, the principle holds: someone has to realize the loss (the fund manager selling something) for the tax deduction to emerge.
- Investors vs. Traders: It’s worth clarifying the term “investor” vs “trader” in tax context. An “investor” typically is someone who buys and sells securities for personal investment, not as a business – they are subject to the standard rules (capital losses, $3k limit, no mark-to-market unless they opt into trader status). A “trader” is actively engaged in trading as a livelihood; they can get the special treatment we described. So if you’re a frequent stock or crypto trader but not officially recognized as a “trader in securities” by IRS standards, you’re still in the investor bucket for taxes. Many people day-trade on the side and mistakenly think they can deduct all their trading computer equipment or all their losses beyond $3k – only if you meet trader status and possibly elect 475 can you do that. Traders also aren’t subject to wash sale rules once they elect mark-to-market (since everything is ordinary and no carryover of basis, the wash sale becomes moot).
- Short Sales and “Phantom” Losses: One scenario to be aware of: if you short sell a stock (betting it will go down), you might see an unrealized loss if the stock price goes up (because you’d lose money to cover the short at current price). But for taxes, a short sale isn’t considered “closed” (realized) until you cover the short by buying the stock back. So an unrealized loss on a short position isn’t deductible either until the short is closed. Similarly, if you have certain derivative positions that fluctuate, the timing of realization is defined by tax rules specific to those instruments. The pattern is the same: open positions = no deduction yet.
- Hedge Accounting / Straddles: Some advanced investor tactics involve deferring losses (like the old trick of selling one position at a loss and buying a very similar one to realize a loss but keep exposure, which the wash sale rule addresses; or entering straddles where one leg has a gain and one a loss and trying to time recognition). The tax code has anti-abuse rules (like wash sales, straddle rules under Section 1092, related-party loss rules, etc.) to prevent “artificial” realization of losses without economic substance. The broad theme: you need a bona fide transaction and cannot immediately undo it without consequences if you want that loss deduction to stick.
Pros and Cons of the Mark-to-Market Election (Traders): If you’re considering electing to treat unrealized losses as realized each year (Section 475), it’s a big decision. Here’s a quick take:
| Pros of Mark-to-Market (Sec 475) | Cons of Mark-to-Market |
|---|---|
| Unlimited Loss Deductions – You can deduct all trading losses in full as ordinary losses (no $3k cap), which can significantly reduce your taxable income in a bad year. | Immediate Tax on Gains – All gains are also recognized each year as ordinary income (no deferral by holding assets, and no lower capital gains tax rates). In a good year, you could owe more, sooner. |
| No Wash Sales – The wash sale rule doesn’t apply to 475 trades. You won’t lose deductions just because you bought back a stock too soon. This simplifies trading – you can jump in and out without 30-day worries. | Complexity & Commitment – Once elected, you generally must stick with mark-to-market annually. Turning it off requires IRS approval. It complicates tax prep (Form 4797 for gains/losses) and can be hard to reverse if your strategy changes. |
| Ordinary Loss Treatment – Losses are not only fully deductible, they can potentially create net operating losses (NOLs) that you might carry forward to other years. This is more valuable than capital losses which are limited. | No Capital Gains Rates – With 475, profits on positions (even held over a year) don’t get the favorable long-term capital gains rate. Everything is treated like business inventory. High-volume traders might not care since they don’t hold long, but it removes the option. |
| Clean Tax Year Cut-off – By marking everything to market at year-end, you start each year fresh. This can simplify tracking and tax projections, as you won’t have hanging unrealized losses or gains. | Not for Everyone – You must qualify as a trader (substantial trading, intent, etc.). Casual investors can’t elect this. If you misjudge and the IRS says you weren’t a “trader,” your election could be invalid and deductions denied. |
| Potential Tax Planning – In certain cases (like expecting a big profit next year but having a big loss this year), mark-to-market might let you use the loss now to offset other income, giving you a timing benefit. | Paperwork & Deadlines – The election has to be made by a strict deadline (generally by the due date of the prior year’s return). Missing the paperwork means you’re stuck with the default rules for that year. |
As shown, mark-to-market is powerful but comes with trade-offs. The vast majority of individual investors do not use it, but for a subset of active traders, it’s an important option.
Different Asset Classes: Loss Deduction Scenarios
Let’s zero in on specific asset types – because unrealized losses can happen in various places, and the tax treatment can have nuances in each:
Stocks & Mutual Funds (Capital Markets)
Scenario: You hold shares of a publicly traded company or a mutual fund, and the market price drops. Until you sell those shares, any loss is unrecognized by the tax system. Stocks and funds are classic capital assets. Tax rule: No deduction until sale or other taxable disposition.
If you sell for a loss, it becomes a realized capital loss. This loss first offsets any capital gains you had for the year (dollar for dollar). If losses exceed gains, up to $3,000 (for individuals) can further offset your ordinary income. Any remaining unused loss carries forward.
For example, suppose in 2025 you sold Stock A for a $5,000 loss and Stock B for a $3,000 gain. Your net capital loss is $2,000. You could use that $2k to offset other income (since it’s under $3k) on your 2025 taxes, reducing your taxable income. Now, if the loss had been larger – say a net $8,000 loss – you’d deduct $3,000 this year and carry $5,000 forward to 2026.
Beware: Timing sales to realize losses is a common tax strategy (tax-loss harvesting), but pay attention to the wash sale rule. If you want to keep exposure to the stock, you can buy a different company in the same industry or an ETF, or simply wait 31 days to repurchase the original stock. Just don’t rush back into the same position, or you’ll lose the deduction.
Also note, if you received shares as a gift or through inheritance, special basis rules apply which can affect the size of your loss when realized (a gifted asset’s basis may carry over or adjust if the value dropped at gift time). But the fundamental remains: until you sell, nothing is recognized.
Cryptocurrency
Scenario: You own some cryptocurrency (Bitcoin, Ethereum, etc.) that has plummeted in value. As with stocks, no sale means no realized loss. Crypto might feel different because it trades continuously and isn’t a traditional security, but the IRS treats crypto as property. So if you bought 1 BTC at $50k and it’s now $20k, that $30k unrealized loss is not deductible until you actually sell or otherwise dispose of the crypto.
Unique point: As mentioned earlier, no wash sale rule for crypto (yet). Crypto investors can sell their coin, realize a capital loss, and even buy the same coin back immediately or whenever they want, and the loss will still count. This is a tax loophole that stock investors don’t enjoy.
It means tax-loss harvesting with crypto is very flexible – you can recognize losses for tax purposes without materially changing your position for long. For instance, at the end of the year you could sell your entire crypto portfolio that’s down, lock in the losses, and then immediately repurchase the same crypto. You’ve harvested the losses for tax relief but still hold the coins (now with a new cost basis equal to the current lower price). Many crypto holders did this in 2022–2023 when markets were down. However, you must actually execute the sale. Just holding through a dip does nothing for your taxes.
Should the law change (and proposals have been made to apply wash sale rules to digital assets), one might have to wait 30 days similar to stocks. But as of 2025, it’s a notable strategy. Keep records of your trades – the IRS is increasingly watching crypto transactions.
Also, if a crypto exchange or project collapses and your coin becomes completely worthless or inaccessible, that’s another scenario. If you can prove a coin became worthless (no market, essentially zero value) or an exchange theft occurred, that could be deemed a realized loss (e.g. an exchange hack might qualify as a casualty/theft loss in some cases, or a Ponzi scheme coin might be a theft loss under certain safe harbor rules). These are complex, but just to note: an outright worthless cryptocurrency can be treated like a sale for $0 – but you need solid evidence of worthlessness (like the blockchain is dead and no trades happen at any price).
Real Estate
Real estate can produce significant losses, but the tax handling depends on whether the property is personal or business/investment:
- Personal Residence: If your personal home’s value drops, or you sell your house for less than you bought it, it’s painful financially but yields no tax deduction. The IRS specifically disallows losses on the sale of personal residences (and any personal-use property). You also cannot write down your home’s value due to market conditions. The tax code gives a big break on gains for a primary home (the Section 121 exclusion lets you avoid tax on a good chunk of profit when selling a home you lived in), but with losses, there’s no corresponding relief.
- Rental or Investment Property: If you own a rental property or other real estate held for investment (like land you hope will appreciate), you cannot deduct market value declines unless and until you sell (or the property becomes worthless, which is rare for real estate to be literally worthless). However, you do get to take depreciation deductions if it’s rental property. Depreciation is a sort of forced gradual loss recognition – each year you deduct a portion of the property’s cost as an expense, reflecting wear and tear. But depreciation is based on original cost, not current market value fluctuations. If the real estate market slumps, you can’t speed up depreciation or take an extra loss. You just continue with the normal schedule. When you eventually sell investment real estate at a loss, that loss is realized and generally deductible as a capital loss (assuming it’s not dealer property or something – most rental or investment properties are capital assets or §1231 assets). One caveat: if you have a rental that also had personal use (like a vacation home you partly rented), you have to allocate and the loss portion might be limited. But if it’s purely investment, a sale below your adjusted basis yields a deductible loss. Real estate losses have some special treatments if it’s §1231 property (business property) – they can sometimes be ordinary losses if not offset by gains, which is actually favorable. But you must get to the sale first.
- Example: You bought a rental condo for $300k. Over some years, you took $50k of depreciation, so your adjusted basis is $250k. The real estate market then crashes, and you sell the condo for $220k after expenses. You’ve realized a $30k loss compared to your adjusted basis. That $30k is now deductible (likely as a §1231 loss, which in this case would be treated as ordinary loss since you have no §1231 gains – meaning it could offset any income). If instead the market crashed and the condo is now worth $220k but you hold onto it, you keep depreciating the original cost; you don’t get to take that $30k decline until an actual sale. If the property later recovers in value, that interim drop never gave you a deduction (nor would a recovery be taxed until sale).
- Abandonment: On rare occasions, a building might be abandoned (say it’s condemned and you walk away). If you abandon investment property, that can trigger a loss equal to your remaining basis, treated as an ordinary loss (not a capital loss, because no sale occurred). But you must really relinquish all rights and not get any value out. Real estate usually isn’t abandoned unless it’s burdensome to keep (perhaps due to environmental issues or liabilities).
- Casualty Losses: If real estate or other property is destroyed or damaged (think fire, hurricane, flood), that’s a casualty loss. For business or investment property, a casualty loss is deductible in the year of the event (with some rules about insurance reimbursements). That’s one scenario where you might deduct a loss in value without a sale, because the destructive event substitutes for a sale (the property’s value was materially lost due to casualty). For personal-use property, after 2017, casualty losses are only deductible if in a federally declared disaster, but if your personal home was in such an event, you could potentially deduct the loss in value (above insurance and a $500 deductible and 10%-of-income threshold). Again, that’s a realized economic loss due to an event. It’s distinct from an unrealized market drop.
In short, real estate held for investment behaves like other investments – wait until sale to get a loss deduction (apart from depreciation or casualty frameworks). Personal real estate: no deduction for value declines or loss on sale.
Inventory and Commodities
We touched on inventory in the business section, but to summarize in context of asset classes: Inventory is treated differently from capital assets. It’s not a capital asset; it’s ordinary property that generates ordinary income or loss. But you still can’t usually deduct an inventory loss until it’s reflected in your cost of goods sold or a write-off of obsolete stock. Many businesses use inventory accounting methods that inherently recognize some decline (e.g., lower of cost or market). If market price falls below cost, businesses can choose that lower value for inventory on their tax return (if their method allows). This effectively realizes the loss in inventory value without a sale. The IRS requires consistency and evidence, as we discussed with the Thor case. So inventory is one area where tax law provides a structured way to take certain unrealized losses – but only in limited, justifiable cases to clearly reflect income.
Commodities: If you’re an investor in commodity futures, Section 1256 mark-to-market covers you – losses on futures at year-end are taken into account automatically. If you physically hold commodities (like a store of gold, or bushels of corn), then those are property and not marked to market for tax – no loss until sale (unless perhaps the goods spoil – which then is like a casualty or inventory issue). For precious metals or collectibles you hold as an investment, again, not deductible until sold and even then those are capital losses (with the $3k limit for individuals, and collectible losses can only offset collectible gains typically because of how capital gains categories work).
Examples: When Losses Are Deductible vs Not
Sometimes it helps to see concrete examples side by side. Here are three common scenarios illustrating unrealized vs realized loss treatment:
1. Stock Investment Loss (Individual Investor)
| Situation | Tax Outcome |
|---|---|
| Jane buys 100 shares of XYZ stock for $10,000. By December, the market value of her shares is $6,000. She hasn’t sold any shares. | No deduction. The $4,000 drop is an unrealized loss. Jane cannot deduct it on her tax return because she still owns the stock. It’s a paper loss only. |
| The following year, Jane sells all 100 shares for $6,000. | Deduction now allowed. The sale realizes a $4,000 capital loss (assuming $10k basis – $6k proceeds). Jane can use that $4,000 loss to offset other capital gains. If she has no gains, she can deduct $3,000 against her job income this year and carry $1,000 to next year. The act of selling turned the paper loss into a tax-recognized loss. |
2. Small Business Inventory Loss
| Situation | Tax Outcome |
|---|---|
| A retailer’s inventory cost $50,000 to stock. Due to a sudden change in technology, those products are now worth maybe $30,000 at most. The goods are still on the shelf at year-end, unsold. | Generally, no immediate deduction. The $20,000 drop is unrealized as long as the inventory sits unsold. The retailer can’t just claim a $20k loss because the market shifted. For tax, that loss isn’t realized until something is done. (If the company qualifies and consistently uses a lower-of-cost-or-market inventory method and can prove $30k is the current market value, it might write down and deduct the $20k decline with IRS approval. But that requires clear evidence and proper accounting – otherwise, no deduction yet.) |
| The retailer decides to liquidate. They sell the inventory in bulk to a discounter for $30,000, or alternatively, they throw away worthless items. | Deduction realized. Now the loss is locked in. If sold for $30k, they realize an ordinary loss via cost of goods sold: the business paid $50k, recovered $30k, so $20k hits as a loss in the profit and loss. If scrapped with no proceeds, the entire $50k might be deductible as a loss (assuming it had been included in inventory). Either way, by disposing of the inventory, the business can take the tax benefit of the loss. Before disposal, it was just a value fluctuation on the shelf. |
3. Cryptocurrency Crash and Tax-Loss Harvesting
| Situation | Tax Outcome |
|---|---|
| Tom purchased 2 BTC (Bitcoin) for $50,000 (so $25k each on average). The crypto market fell, and now 2 BTC are worth only $20,000 total. Tom still holds his 2 BTC. | No deduction yet. Tom’s unrealized loss is $30,000, but because he hasn’t sold, it’s not recognized on any tax form. He can’t deduct a dime of it for now. If the price goes back up later, he avoided a premature deduction that would’ve reversed – that’s why tax waits. |
| Tom decides to harvest the loss: He sells his 2 BTC on December 30 for $20,000 (realizing a $30k loss), then buys 2 BTC back on January 2 for around the same price. | Deduction achieved (legally). Tom’s $30,000 loss is now realized and can be reported on his taxes. He can use it to offset any crypto or stock gains he had, or up to $3k of other income, and carry forward the rest. Because crypto isn’t under wash-sale rules, buying back the 2 BTC doesn’t nullify his loss – he essentially kept his crypto position (only out of the market for a couple of days) and still locked in the tax loss. If Tom had done this with stocks, rebuying so soon would trigger a wash sale and disallow the loss. But with crypto this strategy currently works. Tom has effectively turned an unrealized loss into a realized one without materially changing his investment holdings. (Note: If laws change, one might need to wait 31 days to repurchase crypto to be safe. Also, had Tom simply held the BTC into the new year without selling, he’d have no deduction and would carry the paper loss hoping for recovery.) |
These examples underscore a repeated theme: action (sale or disposition) is required to put losses on your tax return. Until then, losses might as well not exist from the IRS’s perspective.
Mistakes to Avoid (and Myths to Bust)
When dealing with losses, many taxpayers make assumptions that can lead to errors, audits, or missed opportunities. Here are some common mistakes and misconceptions regarding unrealized losses and deductions:
- “I can deduct it because it went down in value.” Nope. As we’ve emphasized, a mere decline in market value is not a deductible event. This misconception often arises with things like real estate (“my house value dropped, can I get a tax break?”), vehicles (“my car’s worth half what I paid, is that a loss?”), or stock (“my portfolio lost money this year, so I won’t owe much tax, right?”). In all these cases, unless you sold the asset (and it’s an asset where losses are allowed), you have no deduction. Don’t try to list “unrealized loss” anywhere on your tax forms – there’s no such line.
- Forgetting the Wash Sale Rule: Some investors do the right thing by selling losers to realize losses, then immediately rebuy because they still like the stock. If this happens within the 30-day window, they later discover the IRS disallowed their loss. This usually comes out when reviewing 1099-B forms or IRS notices. To avoid this, plan your tax-loss harvesting with a bit of foresight. If you want to maintain exposure, consider switching to a similar but not identical investment for 30+ days. For example, sell your OilCo stock for a loss and buy an Energy sector ETF, or sell one tech stock and buy a different tech stock – you change the holding but keep market exposure, without triggering the wash sale rule.
- Trading in December without tracking wash sales: Wash sales reset the loss basis into the new shares. If you did a lot of trading around year-end, you might inadvertently deferral losses into January purchases. That could postpone the benefit of the loss beyond the tax year you intended. Many DIY investors get tripped up by this when preparing taxes. Using software or a broker statement that identifies wash sales is key. But simply, don’t buy the same thing within 30 days of selling at a loss – that includes before and after the sale.
- Misidentifying “substantially identical”: Wash sale isn’t just the exact same stock symbol. It could be triggered by selling a mutual fund and buying a very similar fund, or selling stock and buying call options on that stock within 30 days. For example, selling an S&P 500 index fund for a loss and immediately buying a different S&P 500 index fund from another provider – the IRS might consider those substantially identical. So diversify the strategy (maybe buy a Total Market fund or a different index) to be safe. With individual stocks, just don’t buy the same company (though buying a competitor or sector peer is fine).
- Thinking Year-End Market Value Matters for Taxes: Apart from certain professional situations (like mark-to-market traders or 1256 contracts), the year-end value of what you hold doesn’t directly affect your tax for that year. Some taxpayers mistakenly think they have to report unrealized gains or losses – you do not on your tax return (again, except in those special cases). You report sales that occurred. So don’t go listing all your holdings’ market changes on Schedule D; only list actual sales or dispositions. (Your brokerage 1099-B helps by listing what was sold.)
- Trying to claim a deduction for a “loss on paper” by creative means: This includes schemes like selling an asset to a friend or relative at a loss to generate a deduction, but with a wink agreement that they’ll sell it back later. The IRS has rules (like the related-party loss disallowance under Section 267, and step transaction doctrine) to collapse such schemes. It’s not worth the risk; plus it violates the spirit of the law. If an IRS auditor sees you sold stock to your brother at a loss and he soon after sold it or transferred it back to you, that deduction will vanish and penalties could apply.
- Neglecting Worthless Securities: On the flip side of mistakes, sometimes people forget to claim a loss when they could. If a stock (or even cryptocurrency, or other investment) becomes completely worthless, you are allowed to treat it as sold for $0 on the last day of the year it became worthless. Some taxpayers fail to claim these losses because they didn’t get a 1099-B (since they didn’t sell). But you can still claim it – you’ll often write “Worthless” on Form 8949 for that stock with basis and $0 proceeds. Just make sure the security truly had no value and no chance of recovery in that year (e.g., the company liquidated, shares cancelled). If you miss claiming a worthless security loss in the right year, you could potentially amend or use it in the next year (the tax code provides a bit of leeway if you missed the exact year, but best to do it correctly).
- Assuming your tax software will automatically handle all this: Tax software is only as good as the info you feed it. You need to categorize correctly and input sales. It won’t know that a coin you hold lost value unless you record a sale. It won’t know to disallow a loss unless your 1099-B flags a wash sale. So review your brokerage statements carefully. And for businesses, ensure you adjust inventory or assets correctly on the tax return – often accounting software and tax prep require manual adjustments for write-downs or disposals.
- State tax differences ignorance: A mistake can be not realizing your state tax might treat losses differently. Most states start with federal income, so they implicitly respect the realized vs unrealized framework. But a few states have quirks. For instance, Pennsylvania doesn’t allow net losses in one class of income to offset income in another (so you can’t use capital losses against wage income at all on PA returns – the $3k federal allowance doesn’t exist there). New Jersey only allows capital losses to offset capital gains, no carryforward of excess (so losses are “use it or lose it” each year against gains in NJ). These differences won’t impact whether an unrealized loss is deductible (none will allow that), but they do affect planning for realized losses. Be sure to check your state’s rules on capital losses and whether they conform to federal carryovers, etc., so you don’t assume a deduction you won’t get at the state level.
- Overlooking professional help when large losses occur: If you have significant losses (especially in complex assets like partnerships, real estate ventures, or trades with tricky rules), consider consulting a CPA or tax advisor. Large losses can raise red flags, and you want to ensure you claim them correctly. For example, losses in a partnership or S-corp might be limited by basis or at-risk rules; they also might be suspended by passive activity rules if it’s a passive investment. Those are beyond our main scope, but just note: even realized losses sometimes can’t be deducted immediately due to such rules. Unrealized ones, of course, are out of play entirely.
In summary, avoid anything that sounds like “I haven’t actually lost it yet, but I want a deduction now.” The tax code is built to prevent that, with very limited exceptions. Instead, focus on real transactions and follow the established strategies (like harvesting losses properly) to make sure you get the tax benefits you’re entitled to without crossing the line.
State Tax Nuances: Follow the Leader (Mostly)
It’s natural to wonder if any U.S. state does things differently when it comes to unrealized losses. After all, state tax codes sometimes diverge from the federal code in various ways. The short answer here is that states generally follow the same realization principle – you won’t find a state that lets you deduct an unsold loss either.
Most states with income tax use your federal adjusted gross income (AGI) or federal taxable income as a starting point for state taxes. That means if something isn’t included or deducted at the federal level, it typically isn’t at the state level either, unless the state explicitly modifies it. There’s no state that says “we’ll let you deduct declines in your stock portfolio even if the IRS doesn’t.” They’re in sync on the concept that a loss must be realized.
However, there are a few nuances to be aware of:
- Capital Loss Offset Rules: Some states do not allow the $3,000 capital loss offset against ordinary income that federal does. For example, Pennsylvania taxes different classes of income separately – you can’t mix capital losses with, say, salary. So a PA taxpayer can only use capital losses to offset capital gains, and excess losses aren’t usable in future years (since PA doesn’t have a carryforward for net losses in that category). New Jersey similarly allows capital losses to offset gains in the same year, but excess can’t be carried forward – they just disappear. Contrast that with federal, where you carry forward indefinitely. So, in NJ, if you have a huge capital loss and no gains, you get no immediate benefit and you can’t use it next year either (ouch!). Most states do allow some form of carryforward, but always check.
- State-specific Adjustments: A handful of states decouple from federal treatment of certain specialized things. For instance, if you elected mark-to-market (Sec 475) for federal and have large ordinary losses from trading, some states might not honor that election and could treat your trading losses as capital. This is rare but possible if a state’s code is stuck in an earlier version of the IRC or has special rules for traders. Always verify in states where you file significant investment-related taxes.
- No State Capital Gains Breaks: Some states tax all income (wages, interest, gains) at the same rate with no special treatment for capital gains or losses. Others mirror federal to some extent. But none give special preference to unrealized amounts. States are more likely to be stricter if anything (like NJ’s no carryforward).
- Community Property States: If you’re in a community property state and married filing separately, splitting gains and losses can get complicated by state community property rules. But again, that’s about realized things and how to allocate – not about unrealized.
- Local Taxes: A few local jurisdictions (e.g., some cities) tax income too, usually piggybacking on state or federal definitions. They won’t count unrealized losses either.
The key takeaway: if it’s not deductible federally, it won’t be deductible on your state return in almost every case. And even once you realize a loss, the usage (carryovers, offsets) might be more restrictive at the state level. Always check your state’s tax instructions on capital losses. They often have a worksheet for how to carry losses to future years or not.
One more note: States that have no income tax obviously don’t allow or need any deductions at all – so if you’re in Florida, Texas, etc., this discussion only matters for federal taxes. States with income tax mostly follow Uncle Sam’s lead on timing of income and losses, with a few tweaks in application.
Notable Court Rulings & Tax Code References
It’s worth briefly recapping some of the legal backbone behind these rules. Why are unrealized losses non-deductible? It stems from fundamental tax principles and has been tested in courts:
- Eisner v. Macomber (1920, U.S. Supreme Court): This famous case dealt with a stock dividend as income, but it cemented the idea that income for tax purposes implies *a gain derived from capital, “severed” from the capital. By analogy, a loss would typically require something severed from your wealth. A mere value change with no transaction isn’t a gain or loss “realized” by the taxpayer. While this case was about gains (and has constitutional overtones about defining income), it influenced tax philosophy: realization is a fundamental aspect of taxable income.
- Boehm v. Commissioner (1945, U.S. Supreme Court): This case involved a taxpayer trying to deduct a loss on stock that had become practically worthless. The Supreme Court ruled that a taxpayer must prove the stock became completely worthless in the year they claim – and that the loss wasn’t actually in a different year. The point: you can deduct a worthless security under Section 165 in the year it’s truly worthless, but not before. It underscored that timing matters and the burden of proof is on the taxpayer to show the identifiable event of worthlessness.
- Lucas v. American Code Co. (1930s era): An older case where a company tried to write down the value of assets (due to decline) and take a deduction. The principle from it was similar: no deduction for a shrinkage in value absent a realization event.
- Thor Power Tool Co. v. Commissioner (1979, U.S. Supreme Court): We discussed this in the small business section. Thor Power Tool wanted to deduct an inventory write-down for slow-moving inventory that it hadn’t sold yet (just reduced value on books). The Supreme Court sided with the IRS in disallowing it, emphasizing that tax law does not necessarily follow GAAP and that requiring an actual sale or scrap ensures income is clearly reflected. The Court famously noted that while Thor’s situation (excess inventory) might be common in business, the tax code doesn’t let you take a deduction just for prudently accounting an anticipated loss. This case is now a staple citation whenever someone argues “but my accountant wrote it off, why can’t I deduct it for taxes?” The answer lies in differing objectives: GAAP aims to inform stakeholders, while tax rules aim to measure taxable income with less volatility and more objectivity.
- Wash Sale cases: The wash sale rule (IRC §1091) itself is statutory, so it doesn’t usually get litigated except on what counts as “substantially identical.” There have been cases around people trying to get around it via slightly tweaked instruments. The IRS typically wins if the essence is the same asset. It’s clear: if you trigger a wash sale, the courts uphold denial of that loss in that year.
- Section 165 and others: The tax code sections to be aware of, as they form the legal scaffolding:
- IRC §165 – General loss deduction provision. Key for us: 165(a) “losses sustained during the year not compensated by insurance…”. Also 165(c) limits losses for individuals to business or investment losses (and personal casualty/theft). 165(g) specifically addresses worthless securities, treating them as a loss from sale on the last day of the year.
- IRC §1211 – Capital loss limitation (the $3,000 rule for individuals, and no ordinary deduction for capital losses for corporations).
- IRC §1212 – Capital loss carryovers (rules for carrying forward individual losses, and carryback/forward for corporations).
- IRC §267 – Related party loss disallowance.
- IRC §1091 – Wash sale rule (disallowance and basis adjustment).
- IRC §475 – Mark-to-market for dealers and traders (optional for traders).
- IRC §1256 – Mark-to-market for certain contracts (futures, etc).
- IRC §166 – Bad debt deduction (worthless debts).
- IRC §1244 – Special small business stock losses as ordinary.
- These sections collectively enforce the idea that you either can’t claim the loss yet (in the case of unrealized losses), or if you can claim a loss, here are the limits and conditions.
- Moore v. United States (Supreme Court 2023/2024): A very recent case touching on unrealized income (specifically about the taxation of deemed repatriation of foreign profits under a 2017 law). The Supreme Court in 2023 initially was expected to address whether taxing an “unrealized” form of income is constitutional. They ended up avoiding a broad ruling on that point, dismissing the case on other grounds. But the buzz around it highlighted that “realization” is a deeply rooted concept in U.S. tax, possibly even with constitutional significance. Why mention this? It underscores that forcing recognition of income without realization is controversial; conversely, it implies allowing deductions without realization would be similarly unusual. While Moore was about gains, not losses, the symmetry is noteworthy – if unrealized gains are generally not taxed (with exceptions, like those mark-to-market regimes we mentioned), unrealized losses generally aren’t deducted, except symmetrically in those regimes.
- Tax shelters involving unrealized losses: In the past, some abusive tax shelters tried to manufacture losses (often by taking advantage of mismatches in realization rules). For example, certain partnership or derivative structures in the 2000s tried to let taxpayers claim losses for tax purposes while economically they hadn’t lost anything overall. The IRS and courts shut these down under economic substance and specific anti-abuse rules. The moral: if a strategy’s goal is to get a deduction now for a loss you haven’t economically locked in, it’s likely not going to fly if scrutinized.
In essence, courts have consistently upheld the IRS’s stance: to deduct a loss, you have to show that the loss is real, finalized, and occurred in that tax year. Paper losses, anticipated losses, or reversible declines just don’t meet that bar. Knowing these rulings can give you confidence that the standard advice (“no unrealized losses”) isn’t just pedantic – it’s backed by law and precedent.
Making the Most of Losses: Strategic Considerations
We’ve hammered on what you cannot do (deduct unrealized losses) and the pitfalls to avoid. Let’s end on a proactive note: what can you do to optimize tax outcomes related to losses?
- Tax-Loss Harvesting: This is the practice of selling investments that are down in value to realize losses, typically toward year-end, to offset gains you’ve realized elsewhere. It’s a way to make use of losses that exist on paper by turning them into actual tax savings. Many investment advisors and automated robo-portfolios engage in tax-loss harvesting for clients. The key points:
- Harvest losses to offset any taxable gains you’ve taken (e.g., you sold some winners or had capital gain distributions from funds).
- If you have more losses than gains, harvest up to at least $3,000 more, so you can use that against ordinary income.
- Be careful not to violate wash sales when harvesting (as discussed).
- You can immediately reinvest the proceeds of sold losers into different assets to keep your money in the market (just avoid substantially identical ones).
- Harvesting is especially beneficial in high-income years or if you have large capital gains (e.g., selling a business or property with gain – having some harvested losses can cushion the tax hit).
- If markets recover later, you’ve still locked in the tax benefit of the downturn. If markets keep falling and you still like the asset, you might harvest again later. This strategy essentially turns volatility to your advantage.
- Even if you don’t have gains now, harvesting up to $3k in losses each year to get that deduction can be worthwhile (plus carryover remaining losses). Over a few years, that can add up.
- Rebalancing with Tax in Mind: While not directly about unrealized losses, whenever you rebalance your portfolio, consider the tax impact of selling appreciated vs depreciated positions. Sometimes it’s smart to sell losers rather than winners if you need to raise cash or adjust holdings, because the losers give you a tax deduction whereas winners incur a tax cost. It can be a factor in which assets you trim.
- Using Loss Carryforwards: If you have capital loss carryforwards from prior years (maybe from a market crash or a big one-time loss), plan to use them against gains. Don’t forget them – they carry forward indefinitely for individuals. For instance, if you carried forward $20k of losses, you can realize $20k of capital gains tax-free (because the losses will offset them). That might influence you to take some gains on winners (selling high) if it fits your investment goals, since you have a “free” offset waiting. Essentially, loss carryforwards are an asset in themselves – they will save you tax on future gains or give you those $3k deductions annually. Keep track of them (Schedule D will show your carryover).
- Casualty and Theft Planning: Not exactly something you plan for (no one wants a disaster), but be aware if you unfortunately suffer a casualty (like your business equipment is destroyed, or your home in a disaster) – document everything and claim the losses you’re entitled to. For businesses, these losses are fully deductible and can create NOLs if large. For personal, if federally declared, you can deduct beyond insurance reimbursement, subject to thresholds. This is one case where something became worthless due to a sudden event and you don’t have to sell it to claim the loss.
- Worthless stock/bad debt timing: If you have an investment that’s circling the drain or a debt owed to you that’s unlikely to be paid, sometimes there’s a decision: wait and see, or claim it now. You want to claim in the correct year, but if you’re pretty certain it’s done for, you might decide to claim it as worthless this year rather than next. Conversely, if it might recover or you might get something out of it (like in bankruptcy proceedings), you have to hold off. But don’t forget to actually take the deduction when the time comes. It can be a bit of effort to substantiate, but it’s valuable.
- Mark-to-Market Election (if appropriate): If you are indeed a full-blown trader or run a fund, analyze whether Section 475 mark-to-market election benefits you. If you anticipate more losing years than winning (or you want to avoid wash sale headaches), it could be beneficial. It’s not common for average folks, but in the right scenario it’s a powerful tool. The election deadline (generally by April 15 of the year you want it effective) is crucial.
- Understanding Entity Choices: If you are, say, a high-frequency trader, maybe running your activities through an entity (like an LLC taxed as a partnership or S-corp) with trader status might help centralize things and elect mark-to-market at the entity level. Or if you have a personal investment that’s gone bad, sometimes contributing it to a business entity doesn’t change anything, but certain losses (like Section 1244 stock or ordinary loss treatment on some partnership liquidations) only come if you had the right structure. This is more tax strategy at a higher level, but for example: losses on small business stock (1244) require that the stock was originally issued to you and the corporation met certain criteria. If you meet that, you get ordinary loss treatment up to the limits. If you don’t, it’s a capital loss. So, structure and the nature of the investment matter for how the loss is treated once realized.
- Avoid Emotional Decisions Solely for Tax: Finally, a word of balance – don’t let the tax tail wag the dog. While harvesting losses and planning is smart, you should still make investment decisions primarily on financial merit. Don’t hold a dying investment just because you can’t deduct it now – if it’s a loser with no hope, perhaps selling and moving on (and capturing the loss for tax) is better financially anyway. Conversely, don’t sell something just for a tax loss if you strongly believe it will rebound and you’d kick yourself for not holding it (unless you plan to buy a similar asset or buy it back after wash sale period). Taxes are an important consideration, but they’re not the only one.
By understanding and leveraging the rules, you can turn the unavoidable reality of losses into at least some tax silver linings. But always within the boundaries of the law – which as we’ve detailed, require that losses be real and realized.
Conclusion: The Power of Realization
Can you deduct unrealized losses under U.S. tax law? In almost all cases, no – you must wait until the loss is realized. This fundamental rule keeps our tax system grounded in actual economic events. While it may be frustrating to see book losses with no tax relief, the flip side is you don’t pay tax on paper gains either. The realization requirement provides consistency: you’re taxed (or get deductions) when transactions are completed or events fixed, not for market swings that may reverse.
We’ve explored how this rule applies across the board – from individuals with stock portfolios, to small businesses with unsold inventory, to investors employing advanced strategies. We’ve seen that with careful planning (like tax-loss harvesting or special elections for professionals), you can work within the rules to maximize your benefits. And we’ve underscored the traps to avoid, so you don’t accidentally forfeit a deduction or run afoul of IRS rules by acting too hastily.
In practice, remember these key takeaways:
- No sale, no deduction. Always ask: did I actually sell or dispose of the asset? If not, don’t expect a tax deduction just because value fell.
- Use losses wisely when they occur. Capture the tax value of losses through proper timing and adhering to rules (harvest losses, avoid wash sales, claim worthlessness when appropriate).
- Keep good records. Document your trades, cost basis, and any evidence needed for worthless claims or casualty losses. If audited, you want to show the loss was genuine and finalized.
- Consult experts for big decisions. Especially if considering mark-to-market elections or if you have complex situations like partnerships, professional guidance can be invaluable.
Tax laws evolve, but the realization principle has stood for over a century. It’s unlikely to change drastically except perhaps for the ultra-wealthy (and even then, any such changes would almost surely allow symmetrical loss deductions in some form). For now, understanding this concept is essential for any taxpayer or investor.
So, while you can’t deduct the ones that got away (unrealized losses), you can certainly plan to make the most of the ones you do realize. As the saying goes, “Don’t let a good crisis go to waste” – if the market hands you lemons (losses), at least make some tax lemonade when you can!
FAQ (Frequently Asked Questions)
Q: Can I deduct a loss on investments I haven’t sold yet?
A: No. You must sell or dispose of the investment to realize the loss before it can be deducted on your tax return.
Q: My stock portfolio dropped in value this year. Will that reduce my taxes?
A: No, not by itself. Market value swings don’t affect your taxes until you actually sell stocks and lock in gains or losses.
Q: If my cryptocurrency crashes but I don’t sell, can I claim a deduction?
A: No. Just holding crypto at a lower value gets you no deduction. You’d have to sell or trade the crypto to realize and claim the capital loss.
Q: Are there any exceptions where I can deduct an unrealized loss?
A: Yes, in special cases. For example, traders who elect mark-to-market treat losses as realized yearly, and if an asset becomes completely worthless in a year, it’s treated as a realized loss.
Q: My small business inventory lost value. Can I write that down for tax purposes?
A: Generally not until you dispose of it. You usually need to sell it at a discount or throw it out. Simply revaluing it lower on your books doesn’t give a tax deduction in most cases.
Q: Does the IRS allow any tax relief if my home value goes down?
A: No. Declines in personal home value or selling your home at a loss are not tax-deductible. Tax law does not provide deductions for personal asset losses.
Q: If unrealized gains aren’t taxed, do unrealized losses matter at all for taxes?
A: Not under current law for individuals. Both unrealized gains and losses are generally ignored until realized. Only once realized do they enter your tax calculations.
Q: Is tax-loss harvesting legal and worthwhile?
A: Yes. It’s a common, legal strategy. By selling losing investments to realize losses, you can offset other gains and income. Just be mindful of wash sale rules when you reinvest.
Q: Do state taxes allow me to deduct more of my losses?
A: No. States follow the same idea – no deduction for unsold losses. Some states are even more restrictive on using realized losses (for example, no $3k offset or no carryovers), so know your state’s rules.
Q: If I elect mark-to-market as a trader, will I pay tax on unrealized gains too?
A: Yes. Mark-to-market means you’ll report all gains and losses each year as if sold. You get to deduct losses fully, but you also must pay tax on gains even if you haven’t sold those positions for cash.