Determination of Net Long-Term and Short-Term Gains or Losses
Now that you understand how individual gains and losses are classified, you need to know how the Internal Revenue Service (IRS) nets them together when an investor has multiple transactions in the same year.
The Four-Step Netting Process
When a taxpayer has a mix of short-term and long-term transactions, the IRS uses this process:
- Net all short-term gains against short-term losses = net short-term result
- Net all long-term gains against long-term losses = net long-term result
- If both results are gains: each is taxed at its own rate (short-term at ordinary, long-term at preferential)
- If one is a gain and one is a loss: net them against each other. The result takes the character of the larger amount
Exam Tip: Gotchas
- Net within categories before netting across. Short-term vs. short-term and long-term vs. long-term come first. Only then do you net the two results against each other.
How Character Follows the Larger Amount
This is the rule the exam tests most:
| Net Short-Term Result | Net Long-Term Result | Final Result |
|---|---|---|
| +$5,000 gain | +$3,000 gain | Both taxed separately at their own rates |
| +$5,000 gain | -$2,000 loss | $3,000 short-term gain (taxed at ordinary rates) |
| -$1,000 loss | +$4,000 gain | $3,000 long-term gain (taxed at preferential rates) |
| -$3,000 loss | -$2,000 loss | $5,000 net loss ($3,000 deductible, $2,000 carries forward) |
Key principle: When a short-term gain is offset by a long-term loss (or vice versa), the surviving amount keeps the character of whichever category was larger.
Exam Tip: Gotchas
- Character follows the larger amount, not the gain. If the net long-term loss is bigger than the net short-term gain, the final result is a long-term loss, even though there was a short-term gain.
- When both categories produce gains, they stay separate. Each is taxed at its own rate. They are not combined into a single gain.
Worked Example
An investor has the following transactions in one year:
| Transaction | Amount | Type |
|---|---|---|
| Sold Stock A | +$8,000 gain | Short-term |
| Sold Stock B | -$3,000 loss | Short-term |
| Sold Stock C | +$6,000 gain | Long-term |
| Sold Stock D | -$10,000 loss | Long-term |
Step 1: Net short-term: $8,000 - $3,000 = +$5,000 net short-term gain
Step 2: Net long-term: $6,000 - $10,000 = -$4,000 net long-term loss
Step 3: One gain, one loss, so net them: $5,000 - $4,000 = +$1,000
Step 4: The short-term amount ($5,000) was larger, so the $1,000 result is a short-term capital gain, taxed at ordinary income rates.
Exam Tip: Gotchas
- The exam frequently tests multi-transaction netting scenarios like this one. The character of the final result (short-term or long-term) follows the larger category, not whichever side happened to be a gain.