What Is the Wash-Sale Rule?
The rule defines a wash sale as one that occurs when an individual sells or trades a security at a loss and, within 30 days before or after this sale, buys the same or a substantially identical stock or security, or acquires a contract or option to do so.
A wash sale also results if an individual sells a security, and the individual's spouse or a company controlled by the individual buys a substantially equivalent security during the 61-day wait period.
The point of the rule is to prevent investors from creating an investment loss for the benefit of a tax deduction while essentially maintaining their position in the security.
- A wash sale occurs when an investor closes out a position at a loss and buys the same security (or a substantially similar one) within the 61-day wash sale period.
- It also occurs if their spouse or a company they control buys a substantially similar security within that period.
- The IRS views this activity as creating artificial losses for tax breaks.
- The wash-sale rule prevents taxpayers from deducting an inappropriate capital loss from taxable gains.
- Investors should understand the wash-sale rule so that they can take steps to avoid it.
Wash Sale Rule
How the Wash-Sale Rule Works
The intent of the wash-sale rule is to prevent taxpayers from claiming artificial losses from the sale of securities while essentially maintaining their position in the securities.
The timeframe for the wash-sale rule is 61 days. That is, 30 days prior to the day a transaction takes place and 30 days after. Once that period ends, the wash-sale rule won't apply to transactions involving the same or similar security.
Though a loss may be disallowed due to the wash-sale rule, the amount of that loss will be added to the cost of the purchase that triggered the rule. Then, when that position is later sold, any loss that occurs can be taken as a tax deduction. Therefore, the original loss can be said to be deferred.
The sale of options (which are quantified in the same ways as stocks) at a loss and reacquisition of identical options in the 30-day timeframe would also fall under the terms of the wash-sale rule.
According to Revenue Ruling 2008-5, IRA transactions can also trigger the wash-sale rule. When shares are sold in a non-retirement account and substantially identical shares are purchased in an IRA within 30 days, the investor cannot claim tax losses for the sale. Plus, the loss cannot be deferred in the way described above (by increasing the cost basis of the purchase). It's as if it never occurred.
If you're unaware of wash sales, the wash-sale rule, and its 61-day wait period, you could stymie your legitimate efforts to reduce your taxes. For instance, investors often use tax-loss harvesting to cut their taxable income. This simply involves selling securities at a loss to offset gains elsewhere. If you're unaware of the wash-sale rule and inadvertently re-establish a position in the same or similar securities within the rule's wait period, your tax deduction will be disallowed.
Wash-Sale Rule Example
Say you buy 100 shares of XYZ tech stock on November 1 for $10,000. On December 15, the value of the 100 shares has declined to $7,000, so you sell the entire position to realize a capital loss of $3,000 for tax deduction purposes.
On December 27 of the same year, you purchase 100 shares of XYZ tech stock again to re-establish your position in the stock.
The initial loss will be not be allowed as a tax loss since the security was repurchased within the wash-sale rule timeframe. Instead, it will be added to the cost of the recent purchase. Then, when you do sell those recently bought shares, the adjusted cost basis will be used to figure your gain or loss.
By wash, the IRS means that the transactions at issue cancel each other out. So, there's no real sale, an investor has effectively kept their position in the market, and thus, the loss and tax-deduction are artificial.
Substantially Identical Securities
Stocks or securities of one company are generally not considered substantially identical by the IRS to those of another company. Generally, the bonds and preferred stock of a company are not considered substantially identical to the company’s common stock. However, there are cases in which they could be.
For instance, this would be the case if the bonds or preferred stock are convertible into common stock that has no restriction, has the same voting rights as the common stock, and trades at a price close to the conversion ratio.
Cost Basis Change
If the loss is disallowed by the IRS because of the wash-sale rule, the taxpayer has to add the loss to the cost of the new stock, which becomes the cost basis for the new stock.
For example, consider the case of an investor who purchased 100 shares of Microsoft for $33, sold the shares at $30, and within 30 days bought 100 shares at $32. In this case, while the loss of $300 would be disallowed by the IRS because of the wash-sale rule, it can be added to the $3,200 cost of the new purchase. The new cost basis, therefore, becomes $3,500 for the 100 shares that were purchased the second time, or $35 per share.
Cryptocurrency transactions are not subject to the wash-sale rule. That's because cryptocurrencies are considered property at this time by the IRS. They haven't been designated as securities.
Therefore, losses you may incur in a cryptocurrency transaction may offset, for example, gains from stock transactions and reduce your taxable income. Bear in mind that stocks of companies that are involved in cryptocurrencies are covered by the wash-sale rule. Since the classification of cryptocurrency is in flux, be sure to check with an appropriate financial, accounting and/or tax advisor for updates and before engaging in transactions for tax harvesting purposes.
Ways to Avoid the Wash-Sale Rule
There are some simple techniques that you can use to take losses and yet maintain a position in the market until the wash-sale period has expired.
- Using the example above, if you sold your 100 shares of XYZ tech stock on December 15, you could purchase a tech exchange-traded fund (ETF) or tech mutual fund to retain a similar position in the technology sector, although this strategy does not entirely replicate the initial position. When the 30-day period has passed, sell the fund or ETF and then repurchase your XYZ stock if you so desire.
- If you plan to sell an entire position at a loss in order to offset gains, but still want to own the stock, buy additional shares and just wait out the rule period of 30 days. Then sell your position (perhaps at even a greater loss).
- Buy a call option on the stock you own but wish to sell. Once the wash-sale rule wait period ends, sell your shares and collect your loss. The call option has kept you in the market.
- Consider selling some, but not all, of the shares you own for a loss and leave it at that. You won't have bought any new shares within the rule's window. You'll have a tax-deductible loss and still maintain a position in a stock you believe may appreciate in value. For instance, if you bought 200 shares initially, sell only 100. As soon as the 30 days is up, buy 100 more shares to replenish your position.
How Do I Benefit by Understanding Wash Sales?
If you understand the ins and outs of wash sales as well as the wash-sale rule, you'll be able to make the most of legitimate tax breaks without running afoul of the IRS. By informing yourself on the topic, you can ensure that you:
- Receive tax deductions that you've planned for instead of having them disallowed
- Can work with the rule's waiting period and important end-of-year tax dates
- Buy appropriate, related securities (after selling your original position) to still get the appreciation you're expecting
- Avoid repercussions of breaking the rule while staying in the market
- Can know when the rule has no impact on your transactions
What's the Penalty for Violating the Wash-Sale Rule?
There's no real penalty. If your transaction violates the wash-sale rule, the loss you try to take as a tax-deduction will be disallowed. The amount of the loss must be added to the purchase price of the security you bought that breached the wash-sale rule. According to the IRS, this postpones the loss deduction until the security is sold.
What Is the Purpose of the Wash-Sale Rule?
From the perspective of the IRS, wash sales are attempts to circumvent or manipulate the tax laws. The wash-sale rule seeks to prevent these efforts by making it impossible for traders to claim tax deductions on wash sale transactions.
How Can I Avoid Violating the Wash-Sale Rule?
The wash-sale rule states that, if an investment is sold at a loss and then repurchased within 30 days, the initial loss cannot be claimed for tax purposes. So, just wait for 30 days after the sale date before repurchasing the same or similar investment. When in doubt, investors wishing to comply with the wash-sale rule should consult with an appropriate tax advisor or other qualified professional.
How Do I Know If a Security Is Substantially Identical?
Unfortunately, the IRS does not specifically define what the term substantially identical means. It does provide guidance in Publication 550, however. For example, a company involved in a reorganization will likely be considered to have substantially identical securities to those of the new company. The IRS states that investors must rely on their own judgment and the advice of professionals to determine substantially identical securities.