The market slump has left many people with capital losses. How can you make the best use of them?
Although no investor sets out to make a loss when buying and selling shares, the decline of household names such as Woolworths, Lloyds Banking Group (LSE: LLOY) and BT (LSE: BT-A) means that the effect of the current recession on company shares, and the likelihood of generating a capital loss on sale cannot be underestimated.
In much the same way that capital gains earned when shares are sold at a profit are charged to tax, capital losses will provide relief from tax. However, capital losses are, essentially just that, capital losses, meaning they can only be relieved against capital gains and not against income.
Of course, many people would rather set these losses against income, given most people will have income annually, but gains only sporadically. Furthermore, losses against income would give relief at 40% or even 50% instead of the 18% capital gains tax rate, which may be why it is possible to set income tax losses against gains under certain circumstances, but not the other, more taxpayer-friendly, way round.
Calculating Losses
In simple terms, losses are calculated in the same way as gains by deducting allowable cost from the proceeds received (if any) on the disposal of shares.
Allowable costs include the price paid for the shares (calculated with reference to the share matching rules if appropriate) and any Stamp Duty Reserve Tax paid on share purchase. Broker's costs and commissions on purchase and sale can also be deducted, but only those relating purely to the transaction in question.
Indexation no longer applies to gains and losses made after 5 April 2008, but where it previously applied, it could neither create nor augment a loss, i.e. any loss could not be increased by indexation, and if a transaction only generates a loss because of indexation, the indexation applied will be limited such that the gain is reduced to Nil.
Of course, the reasoning behind indexation was to compensate for the expected increase in value of an asset over time akin to inflation, so there is no economic reason why indexation should be restricted in this way (or indeed abolished entirely), but that's beside the point. Perhaps.
Interaction of losses and the annual exempt amount
Any capital losses that cannot be set off against same year gains may only be carried forward indefinitely until a suitable gain arises, the only exception being on death, as losses carried forward do not hold much value in the afterlife.
As individuals each benefit from an annual exempt amount of (currently) £10,100, it would be advantageous for taxpayer to use up only that amount of any losses generated in the year so as to reduce any gains to £10,100. This would mean no capital gains tax would be due and the losses carried forward for future use would be maximised, which is probably why HM Revenue and Customs do not allow you to do so.
Instead, all available current year losses must be set against current year gains until one or other is exhausted. If there are still excess losses, these may be carried forward, but the benefit of the annual exempt amount remains lost. This means that current year losses, instead of being worth 18p in the pound (little, but better than nothing) are, when displacing the benefit of the annual exemption in this way, actually worth nothing at all.
However, once losses have been carried forwards to a subsequent year, they may then be set against gains after deduction of the annual exemption meaning they will only be used where gains exceed the annual exempt amount, and will otherwise be carried forwards until they can be used.
Death and (capital gains) taxes
You will be pleased to know that capital gains tax does not apply on death. Even better, on death, assets pass to beneficiaries at probate value, normally the market value on the date of death, so someone inheriting then immediately selling an asset would bear little or no capital gains tax liability.
However, there are rules to deal with gains in the year of death, as the deceased may have bought and sold shareholdings right up to the day of his death. Only actual disposals are considered -- there is no apportionment of gains notionally arising on assets held on death and a full year's annual exemption is available, even if clogs are popped on 6 April.
The rule about setting off current year losses first, before the annual exempt amount, also applies in the tax year of death. However, if there are excess current year losses, which, understandably, cannot be carried forwards, they may be set against gains of the preceding three years, starting with the most recent. Any such losses carried back should be set off after brought forward losses from previous years.
So, just inheritance tax to worry about now then…
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