That section (albeit the part about withdrawal by the filing due date) refers to a loss: "If there was a loss, the net income you must withdraw may be a negative amount." Does that apply to withdrawals after the filing deadline?
No, only to a return of contribution before the due date of the tax return. Because the tax code permits an excess to simply be applied as a subsequent year's contribution, if eligible, no adjustment for earnings is done after the due date of the tax return and imposition of the 6% excess-contribution penalty. Applying the excess as a subsequent year's contribution is equivalent to taking a distribution of the exact amount of the excess and using that money to make a new contribution.
but is it the IRS' intent to tax earnings but ignore the implication of a loss?
Yes, if the distribution is made before the due date of the tax return, otherwise both gain and loss are ignored.
Imagine a case where a Roth IRA started with a $1,000 balance, a contribution was made for $6,500 (an excess of $1,000, which is later withdrawn). If that $7,500 account dropped in value to $5,000, must you still withdraw the $1,000 excess rather than prorate the account balance?
If done after the due date of the tax return, yes.
Distribution of the excess before the due date of the tax return and distribution of the excess after the due date of the tax return are covered by separate subsections of section 408 of the tax code.
That instruction section also said, "In most cases, the net income you must withdraw will be determined by your IRA trustee or custodian." The IRA custodian made the calculation and distributed less than the excess contribution, so they must think (right or wrong) that the contribution return must be prorated to reflect the loss.
That instruction applies to a return of excess contribution before the due date of the tax return.
The IRA custodian should not have done any earnings calculation on the distribution of the 2018 excess since the distribution was made after the due date of the 2018 tax return, including extensions. The fact that they mistakenly did this calculation suggests that the IRA custodian is inexperienced, perhaps a smaller bank. Unfortunately, it's common for smaller banks to mishandle various transactions involving IRAs, partially because the statutes and regulations involving IRAs are so convoluted. (That's why I decided years ago to educate myself on these matters.)
Unless you intend to pursue compensation from the IRA custodian for the $20 excess contribution penalty that you have for 2020 (that you would not have had had the IRA custodian not inappropriately adjusted the $1,000), there is no need to involve the custodian in determining how much to have distributed from the IRA to correct the remaining $200 excess. Simply request a regular distribution of $200 without mentioning that it has anything to do with an excess contribution. Because it's so common for the smaller IRA custodians to mess this up, it's common for that those who understand the nature of this to suggest that no mention be made of an excess contribution when obtaining the regular distribution necessary to correct an excess contribution after the due date of the tax return.
