Read § 1222. You will see that the Code distinguishes between sales or exchanges of capital assets held for one year or less, and sales or exchanges of capital assets held for more than one year. 1 Sections 1221(3 and 4) inform us that every single sale or exchange of a capital asset gives rise to one of the following:
- short-term capital gain (STCG);
- short-term capital loss (STCL);
- long-term capital gain (LTCG);
- long-term capital loss (LTCL).
Sections 1221(5, 6, 7, and 8) direct us to net all short-term transactions and to net all long-term transactions.
- net short-term capital gain (NSTCG) = STCG − STCL, but not less than zero;
- net short-term capital loss (NSTCL) = STCL − STCG, but not less than zero;
- net long-term capital gain (NLTCG) = LTCG − LTCL, but not less than zero;
- net long-term capital loss (NLTCL) = LTCL − LTCG, but not less than zero.
Notice the precise phrasing of §§ 1221(9, 10, and 11). The definitions of these phrases is in § 1222, but other code sections assign specific tax consequences to them. Section 1222(11) defines “net capital gain” to be
NLTCG − NSTCL
We defer for the moment the definition of “net capital loss” to the discussion of capital loss carryovers. 2
Notice that the definitions of § 1222 implement, at least initially, a matching principle to gains and losses. Short-term losses offset only short-term gains. Long-term losses offset only long-term gains.
Net short-term capital loss offsets net long-term capital gain. Section 1222 does not allow any other mismatching. The matching principle is very important because only the LTCG that remains after allowable offsets (LTCL and NSTCL) is subject to tax at reduced rates; other income is subject to tax at higher “ordinary income” rates.