 # Back to basics: Section 1244

The “silver lining” from the last post of being able to write off the capital loss against other capital gains was a dull, scuffed silver. Today’s silver lining, called Section 1244, is a burnished, luminous, refulgent gleaming silver.

Section 1244 of the tax code (primary source here as usual) says that a capital loss on a small business stock can be treated as an ordinary income loss if the loss was on the first \$1M invested in the company.

What does that mean? Recall back to the first post in this series: two types of income – ordinary income and capital gains; two corresponding tax rates – ordinary income rates and capital gains rates, with ordinary income rates being higher.

Section 1244 says you can consider the capital losses to be ordinary losses. Why does that matter? Because the tax rates on ordinary income are higher, and so it’s better for you to reduce your ordinary income rather than your capital gains, if you can.

In numerical form, consider this scenario: you earn \$5,000 in ordinary income from your work, and make two \$5,000 investments, where one returns 3x and one is a total loss.

• Scenario 1: consider the loss a capital loss.

• Ordinary income: \$5,000

• Tax you owe on that (assuming a 37% ordinary tax rate) = \$1,950

• Net capital gain is \$5,000 (\$10,000 net gain on the first investment, minus \$5,000 capital loss on the second)

• Tax you own on that (assuming a 20% capital gain rate) = \$1,000

• Total “income” = \$20,000; total taxes paid \$2,950

• Scenario 2: consider the loss an ordinary loss.

• Ordinary income: \$5,000 less ordinary loss from investment #2 of \$5,000) = \$0 income

• Tax you owe on that (assuming a 39% ordinary tax rate) = \$0

• Net capital gain is \$10,000 (net gain on the first investment

• Tax you own on that (assuming a 20% capital gain rate) = \$2,000

• Total “income” = \$20,000; total taxes paid \$2,000

You don’t have to use a spreadsheet to see that scenario #2 is better. Enjoy that extra \$950 in your pocket.