What Is the Wash Sale Rule and Its Impact on Taxes?
If you’re an investor, you’ve probably sold some of your securities or stocks following a massive price drop to capitalize on losses for tax purposes. It’s a great way to harness your losses to offset capital gains.
But when you’re attached to a security and can’t bear the losses, can’t you sell the stock and then buy it back immediately to harvest a tax loss? The short answer is no. This is exactly what the wash-sale rule is meant to prevent — maximizing tax benefits to claim a capital loss on income taxes at the end of a calendar year.
What Is the Wash Sale Rule?
The wash-sale rule is an Internal Revenue Service regulation that prevents investors from harvesting tax-loss benefits from a security or a stock sold in a wash sale. According to IRS Publication 550, “A wash sale occurs when you sell or trade stock or securities at a loss and within 30 days before or after the sale you:
- Buy substantially identical stock or securities,
- Acquire substantially identical stock or securities in a fully taxable trade,
- Acquire a contract or option to buy substantially identical stock or securities, or
- Acquire substantially identical stock for your individual retirement arrangement–IRA–or Roth IRA.”
Typically, a wash sale results when you dispose of a security or stock at a loss and buy back a substantially equivalent stock within 30 days. If you sell a security and your better half — a company you manage — purchases substantially equivalent security during this period, this is also a wash sale.
How Does the Wash-Sale Rule Work?
The purpose of the wash-sale rule is to prevent investors from claiming unreal losses. If you sell securities at a loss and buy similar securities within 30 days, the loss is taxable. If you sell options at a loss and reacquire matching options during the 30-day period, the wash-sale rule also applies. Thus the full wash sale time frame is 61 days — 30 days before and 30 days after the loss-sale date.
Wash Sale Rule Example
Let’s say you purchase 100 shares of ABC stock on April 1 for $1,000. On May 20, the value of the shares declines to $600, and you decide to sell the whole position to harvest a tax loss of $400. You can claim this loss when tax season arrives. If, however, you sold and repurchased the shares anytime between April 2 and May 1, then the sale on May 20 would be a wash sale, and the loss would be taxable.
Good To Know
The wash-sale rule isn’t only about stocks; it also covers obtaining options to buy stock and purchasing equivalent shares for your traditional IRA or Roth IRA. So, you can’t harvest a tax loss if you repurchase shares within the 30-day time frame.
If the IRS disallows the loss that resulted from the wash-sale rule, you can then add the disallowed loss to the cost of the new security.
For example, if you purchased 100 shares of a particular stock at $50 ($5,000), sold the shares at $40 ($4,000), and then repurchased 100 shares of the same stock at $45 within 30 days for $4,500. Here, the IRS can disallow the loss of $1,000 and add it to the $4,500 so that the new cost basis becomes $5,500. Typically, the cost per share will be $55 instead of $45.
Wash Sale Rule: Frequently Asked Questions
How do I avoid a wash sale?
The wash-sale rule asserts that if a stock or a security is sold at a loss and repurchased within 30 days, the initial loss doesn’t qualify as a taxable loss. To avoid a wash sale, don’t repurchase shares in the same stock within the 30-day period. Simply put, you need to wait at least 31 days before you repurchase the same investment.
How do I know if a security is “substantially identical?”
The IRS doesn’t provide any specific guidelines on how to know whether a security is substantially equivalent. However, you’re clearly violating the wash-sale rule when you sell shares for one company and repurchase equivalent shares within 30 days after the sale.
Keep in mind that the securities you repurchase might be deemed “substantially identical” to the ones you sold if the two securities are similar enough. When in doubt, consult a qualified tax advisor, especially if you want to comply with the wash-sale rule.
Is a wash sale a bad thing?
A wash sale is not bad in and of itself. The only situation when a wash sale might seem like a bad thing is when you violate the rule — selling a security or a stock at a loss and repurchasing the same investment within the period that designates it a wash sale.
Data is accurate as of May 12, 2021, and is subject to change.
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