Unlike capital losses, which can be used to offset only capital gains,1 ordinary losses can be used to offset both ordinary income and capital gains.2 With respect to income, because of the rate differential between ordinary income and capital gain, the government takes a much bigger piece of an individual taxpayer’s ordinary income pie than of than of an individual taxpayer’s capital gains pie.3 All other things being equal, then, individual taxpayers prefer ordinary losses to capital losses and capital gains to ordinary income.4

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  1. Individual taxpayers may deduct up to $3,000 of any excess capital losses from ordinary income, but must carry forward amounts above $3,000 to the following tax year subject to the same strict limitations.
  2. Technically, because of the effective 40.8% rate on non-compensatory ordinary income and effective 23.8% rate on capital gains for individual taxpayers taxed at the highest marginal rates, taxpayers receive a greater benefit when they use ordinary losses to offset ordinary income. Still, it is beneficial to use ordinary losses against capital gains.
  3. Individuals earning more than $500,000 per year face the highest marginal rate of 37% federal income tax on ordinary income and a 3.8% net investment income tax. The capital gains rate on long-term capital gains greater than $426,700 is 20%, but capital gains will likely also be subject to the 3.8% net investment income tax, hence the 23.8% effective rate.
  4. Notably, however, this general rule does not apply to every taxpayer.