For a self-employed individual or a member of a partnership, making a trading loss can be a disheartening experience. However, the UK tax system provides several valuable, albeit complex, options for using these losses to reduce tax liability, either by generating an immediate tax refund or by lowering tax bills in future years. Understanding and strategically applying these ‘loss relief’ provisions is a key aspect of sophisticated tax management.
Identifying a Trading Loss
A trading loss occurs for a tax year when the total allowable expenses of the business, plus any capital allowances claimed, are greater than the business’s turnover or income for the same period. The loss is calculated using the same principles as for calculating a profit, and can be determined using either the cash basis or the traditional accruals basis of accounting.
It is important to note the interaction between trading losses and the £1,000 tax-free ‘trading allowance’. A taxpayer can elect to use this allowance instead of claiming their actual expenses. However, if they do so, they cannot also claim relief for a trading loss. For a business with low income but expenses that create a loss, it is almost always more beneficial to forgo the trading allowance, calculate the loss based on actual expenses, and then claim one of the available loss reliefs. For example, if a business has an income of £800 and expenses of £1,200, it has made a loss of £400. The taxpayer can choose to either use the trading allowance (in which case the £800 income is tax-free, but the £400 loss is wasted) or to calculate and claim the £400 loss, which can then be used to reduce other tax.
Sideways Loss Relief: Offset Against Other Income
One of the most powerful forms of loss relief is known as ‘sideways relief’. This allows a taxpayer to set their trading loss against their other taxable income from the same tax year, or the preceding tax year. This is particularly valuable for individuals who have a PAYE job alongside their self-employment, as the trading loss can be used to generate a refund of the tax paid on their employment income.
The loss can also be set against any capital gains, but only after it has been fully utilised against other income in a given year. A critical restriction applies to this type of claim: HMRC rules state that partial claims are not permitted. The taxpayer must use the entire loss, or as much of it as is needed to reduce their other income to zero. This can sometimes be inefficient. For example, if a taxpayer has £10,000 of other income and a £15,000 trading loss, claiming sideways relief would reduce their other income to £0. This would waste their tax-free Personal Allowance (currently £12,570), as there would be no income left to set it against. In such cases, it may be more tax-efficient to use a different form of loss relief, such as carrying the loss forward.
Carry-Forward and Carry-Back Relief
If a loss is not used via sideways relief, several other options are available, each with specific rules on timing and application.
- Carry-Forward Relief: This is the default and simplest option. If no other claim is made, the trading loss is automatically carried forward to be set against future profits from the same trade. The loss must be used against the first available profits in subsequent years and can be carried forward indefinitely until it is fully utilised.
- Early Years Carry-Back Relief: This is a special relief for new businesses. If a loss is made in any of the first four tax years of trading, it can be carried back and set against the taxpayer’s total income from the three tax years immediately before the year of the loss. Crucially, the loss must be applied against the income of the earliest of these three years first. This can generate a significant tax refund from years when the individual was perhaps in full-time employment before starting their business.
- Terminal Loss Relief: When a business permanently ceases to trade, a special ‘terminal loss’ can be calculated, which includes the loss from the final 12 months of trading. This loss can be carried back and set against the trading profits of the final year and the three preceding years. In contrast to the early years relief, terminal loss relief must be applied against the profits of the latest year first before being carried back to earlier years.
The specific and often counter-intuitive ordering rules for these reliefs mean that care must be taken when making a claim on the Self Assessment return to ensure it is valid. The ‘Any other information’ box on the return should be used to clearly state which type of loss relief is being claimed and how the loss has been allocated against the income of specific tax years.
FQAs
1. What exactly is “trading loss relief” and how does it turn a loss into a “gain”?
Trading loss relief, often called “tax-loss harvesting,” is a tax strategy. It doesn’t magically make a losing trade profitable. Instead, the “gain” comes from using your realized investment losses to reduce your tax liability. You can use these losses to offset capital gains you’ve made on other investments. If your losses exceed your gains, you may be able to use the remaining loss to offset a portion of your ordinary income (like your salary), depending on your country’s tax laws. The result is a lower tax bill, which is a tangible financial gain.
2. How does the process of offsetting gains with losses actually work?
The process involves two key steps: realizing the loss and reporting it correctly.
- Realize the Loss: You must sell the losing asset. An unrealized loss (a stock that is down but you still hold) cannot be used for tax purposes.
- Offset Gains: When you file your taxes, you first use your capital losses to cancel out any capital gains. For example, if you have a $5,000 gain from selling stock A and a $3,000 loss from selling stock B, you would only be taxed on the net gain of $2,000 ($5,000 – 3,000).
- Deduct from Ordinary Income: If your losses are greater than your gains for the year, most tax jurisdictions allow you to deduct a certain amount of the excess loss against your regular income, further reducing your tax burden.
3. Are there any rules or traps I should be aware of, like the “Wash Sale Rule”?
Yes, tax authorities have rules to prevent abuse of loss relief. The most common one is the Wash Sale Rule. This rule disallows a loss deduction if you sell an asset at a loss and then buy back the same or a “substantially identical” asset within a specific period (typically 30 days before or after the sale). To claim the loss, you must wait until this window has passed to repurchase the asset, or you can buy a similar but not identical asset (e.g., a different tech stock or an alternative ETF).
4. Do all types of trading losses qualify for this relief? What about crypto or forex?
This depends heavily on your jurisdiction’s tax laws.
- Stocks & Securities: Losses from stocks, bonds, ETFs, and mutual funds generally qualify as capital losses.
- Cryptocurrency: In many countries, cryptocurrencies are now treated as property, and losses from selling them are treated as capital losses, making them eligible for relief.
- Forex & Options: The tax treatment for forex, futures, and options can be more complex. They might fall under different tax rules (e.g., Section 1256 contracts in the U.S., which have unique tax treatments). It is crucial to understand how your local tax authority classifies each asset type to know if the losses are deductible and how.
5. Beyond taxes, what are the key strategic lessons to learn from a trading loss?
While tax relief is a valuable tool, the most important “gain” from a loss is the lesson learned. A loss is a direct feedback signal from the market. Use it as an opportunity to:
- Review Your Strategy: Why did the trade fail? Was it a flaw in your analysis, poor timing, or an emotional decision?
- Assess Your Risk Management: Did you have a stop-loss in place? Was your position size too large for your account? A loss often highlights weaknesses in risk control.
- Analyze Your Psychology: Did you hold on to a losing trade too long hoping it would turn around? Did you sell in a panic? Understanding your emotional biases is critical for long-term success.