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Wall Street’s Stealth Tax Break

A tax break that could be the biggest in the US has never gotten its due.

For Wall Street itself, the tax break on stock market losses is simply a fact of life. (Photo: A. Golden)

A tax break that could be the biggest in America has never gotten its due. The break on stock market losses flies under the radar, unseen and uncounted, shifting up to 39.6 percent (the top marginal rate) of investment losses onto the US Treasury.

And nobody suggests that this tax break should be reined in. For that matter, nobody pays it any attention at all.

Let’s see how the break operates, and how it’s totally overlooked. Then let’s give it the scrutiny it deserves – especially with Congress signaling that it might be getting serious about tax reform.

Stock market losses turn into tax breaks when the losses are written off against gains on tax returns. This costs the Treasury revenue, and effectively shifts part of the cost onto other taxpayers. All tax breaks do likewise, but this one has bells and whistles besides.

Each year, in addition to unlimited, direct write-offs, losses up to $3,000 can be deducted from ordinary income. Then there’s the cherry on top: any losses that still haven’t been written off can be carried forward indefinitely.

They are, and the total is staggering. The Internal Revenue Service recently estimated capital loss carryovers on 2012 returns at $581 billion ($369 billion long term, $212 billion short term). The Treasury will be picking up part of that $581 billion. Year after year, it picks up part of those $3,000 deductions. With every Wall Street loss, in every regular, non-retirement account, it loses more revenue somewhere down the road.

Yet Treasury shortfalls from market losses aren’t even listed on a definitive ranking of tax breaks compiled by the bi-partisan Joint Committee on Taxation. When lawmakers target these breaks (or tax expenditures, as they’re sometimes called), they tend to focus on the supposed biggest: employer-provided health insurance ($143 billion in 2014), tax-deferred retirement plans ($109 billion), and preferential rates on capital gains and dividends ($91 billion). In truth the unlimited write-off of capital losses could top them all – but the pieces have never been added up and compared to other breaks. Capital losses reported to the IRS include non-market losses too, muddying any possible comparison.

All that aside, it’s time for President Obama and Congress to reform this long-ignored drain on the Treasury.

The president’s 2013 budget proposed capping two other tax breaks, mortgage interest and charitable contributions, at 28 percent; he could propose the same for stock market losses. Limits on the losses that can be written off by individual taxpayers could be phased in. Time limits could be laid down. The yearly $3,000 deduction could be ended. There’s a case for allowing stock market losses to be written off against gains; there’s no good reason, though, to allow the write-off against ordinary income.

Could Wall Street survive without a tax break to help ease the pain of losses? It’s hard to imagine. All the same, with economic inequality at Gilded Age levels, Congress could at least throttle back on one of the policies that drive inequality higher.

For Wall Street itself, the tax break on stock market losses is simply a fact of life. It’s always been touted, especially during tax season. Financial advisors continually urge investors to lower their tax bills by “harvesting” tax losses. It’s a telling use of the word “harvesting” – in this case, harvesting what could well be the biggest tax break of all.