Tax consequences of short term capital losses

Question

How do short term capital losses figure into taxable income? If someone has 50k of taxable income before considering capital gains (and losses) and a total of $2k in short-term capital losses, what is the tax consequence? I understand I'm asking for a simplified answer, but I want to understand the basic principle.

1. The short term capital losses only offset other capital gains, so if there are no capital gains, the taxable income is still $50k.

2. The short term capital losses reduce taxable income to $48k.

3. Something entirely different.

Answer 1

Capital losses offset capital gains. If you have long term capital gains - your short term losses will offset them. After that - total capital losses (if your gains are less than your losses) offset your general income up to a certain level ($3000 for a single person). If you still have losses remaining that are above that level - you carry them over to the next year and repeat the offsetting and carrying over until you've offset all the losses.

IRS Publication 550.

So in your example, assuming you only have $2K capital losses and no gains - it would be the choice number 2: you offset your income and pay taxes on $48K.