How Can You Use Capital Losses to Boost Long Term Wealth?

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With investment markets down significantly so far this year, worrying about Capital Gains Tax (CGT) isn’t something many of us will be doing. With the stock market being so volatile, capital losses are more likely to be on the menu, and this might leave you thinking that you can forget about tax altogether. 

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Now whilst you might not have to pay tax when markets crash, it can be a great time to make moves that could reduce your tax burden in the future. In some ways, capital losses can actually help your long term investment strategy. Sound a bit weird? Let me explain.

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When Do You Incur a Capital Loss?

First things first, let’s consider when you actually realise a capital loss. Just because your share portfolio drops doesn’t mean you’ve lost any money. The stock market is notoriously volatile, and prices move up and down almost every second of every trading day.

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The most important thing to remember is that you only realise a capital loss when you sell an asset. If you hold shares in a company that’s down 10%, you’ve not locked in that loss until you sell it. It might go back up if you hold on to it, which is why falls in value are referred to as ‘unrealised’ capital losses.

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How Can You Use Capital Losses?

So you’ve sold some shares or an ETF for a loss, and you might be feeling a bit bummed. You’ve lost money, and that sucks. But fear not. That loss may come in handy in the future. Why? Because realised capital losses can be offset against any future capital gains, you make! The really good part is that they can be carried forward, forever, until you’ve used them up.

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Let me show you an example of how this could actually work out well for you in the long run.

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Let’s say you invest £20,000 into Johnny’s Bubblegum (JBG). Johnny turns out to be a rubbish CEO, the business hits the skids, and the share price drops 10%. You have a look into the company and decide that Beth’s Bubblegum (BBG) is a better long term bet. You sell your shares in JBG and cop a £2,000 realised capital loss on your investment.

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Then you take your remaining £18,000 and invest that into BBG, which goes on to do really well for you over the next five years. It’s grown steadily, it’s now worth £32,000, and you decide you want to cash in and spend the money. You now have a capital gain of £14,000, and HMRC is going to want a cut! You’ve got your annual CGT allowance of £6,000, which is handy, but it still means you’ve got to pay CGT on the leftover £1,700.

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Or do you?

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No! Our mate Johnny wasn’t great at running a bubblegum empire, but the £2,000 loss you made on his company five years ago will be pretty useful now. As I mentioned before, capital losses can be carried forward indefinitely and offset against future gains. So in this example, you can now use £1,700 from your previous loss to offset the gain from BBG and not pay any CGT at all! Because you’ve still not used £300 of the carried forward losses, they can continue to be carried forward until you have another gain in the future to offset them against.

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The Benefits of Capital Losses

No one likes to see their investments drop in value, and in a perfect world, we’d all have investment portfolios that only went up. Unfortunately, that’s not real life, but it doesn’t mean we can’t take advantage of the main benefit of capital losses, which is to offset future gains.

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Because you can use capital losses in this way, periods of big volatility in the stock market can be a good time to review your investments and cut holdings that aren’t working for you. It’s not about trying to time the market and jumping from one investment to another, but if you can shift your money from something you don’t think has the potential for good long term returns into something that you think does, taking the loss may not be the end of the world.

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