What Is an Ordinary Loss?
An ordinary loss is a loss realized by a taxpayer when expenses exceed revenues in normal business operations. These losses are distinctly different from capital losses and are fully deductible against income, thus reducing the tax owed by the taxpayer.
Grasping the Concept of Ordinary Loss
Ordinary losses can arise from various scenarios, such as casualty, theft, and more. When these losses exceed gross income for the tax year, they become deductible. There are distinct rules and rates associated with ordinary and capital transactions. While ordinary loss deductions are tied to the taxpayer’s marginal tax rate, the net long-term capital rates are generally lower.
In 2022, the ordinary tax rates varied across seven tax brackets ranging from 10% to 37%, whereas net long-term capital rates were from 0% to 20%. Taxpayers in the highest bracket may also need to pay a 3.8% Net Investment Income Tax (NIIT).
Key Takeaways
- An ordinary loss occurs when business expenses surpass revenues.
- They differ from capital losses and are fully deductible against income.
- Capital losses arise when capital assets are sold for less than their cost and have deductible limits.
- There is no limit on the deductible amount for ordinary losses in a tax year.
Ordinary Loss vs. Capital Loss
An ordinary loss refers to losses not classified under capital losses. For instance, the sale of inventory, supplies, business property, and intellectual property constitutes an ordinary loss if expenses exceed revenues.
Example: Suppose you spend $150 writing a book and sell it for $140. You now have a $10 ordinary loss.
Ordinary losses also stem from circumstances like casualty, theft, or certain sales such as Section 1231 property, which includes real or depreciable goods used in a trade or business held for over a year.
Ordinary Losses for Taxpayers
Taxpayers often favor ordinary deductions as they generally offer better tax relief compared to long-term capital losses. Ordinary losses are mostly deductible within the year they are incurred, providing substantial tax counterbalance. In contrast, capital losses are only deductible against capital gains and up to $3,000 of ordinary income, with any excess carried over to successive years.
Example Scenario: You earn $100,000 in a tax year and incur expenses of $80,000. You profit $2,000 from stocks within six months but face a $14,000 loss on stock sold after a year resulting in a net $10,000 capital loss.
Here’s how you would calculate your losses and gains:
- Net short-term capital gains and losses: $2,000 - $1,000 = $1,000
- Net long-term capital gains and losses: $3,000 - $14,000 = $11,000
- Total net capital loss: $1,000 - $11,000 = $10,000
- Net ordinary income: $100,000 - $80,000 = $20,000
- Balance with net capital loss offset: $20,000 - $3,000 = $17,000
- Carry forward the residual $7,000 capital loss for future deduction.
How Much Ordinary Loss Can You Claim on Taxes?
An ordinary loss is fully deductible against taxable income with no restrictions on the amount.
Can You Carry Over Ordinary Losses?
Ordinary losses are deductible in the year they occur. However, exceeding capital losses can be carried forward to future years.
Difference Between Ordinary Loss and Capital Loss
A capital loss happens when selling a capital asset for less than its cost. For example, selling equipment bought at $8,000 for $6,000 results in a $2,000 capital loss. Alternatively, an ordinary loss occurs when business expenses exceed business income or in specific non-capital transactions.
Related Terms: marginal tax rate, capital loss, deduction, net investment income tax, Section 1231 property.
References
- IRS. “IRS provides tax inflation adjustments for tax year 2022”.
- IRS. Topic No. 409 Capital Gains and Losses.
- IRS. “Questions and Answers on the Net Investment Income Tax”.
