When doing the taxes for people that have just started to dip their toes into the world of investing in stocks, I have found that very few knew about the wash sale rules. Yet, this could cause you to pay a lot more in taxes than you need to if you don’t watch the calendar.
Essentially, a wash sale occurs when you sell a security at a loss and then purchase the same security again within 30 days. The wash sale rule goes into effect 30 days before and after the sale, so you have a 61-day window to avoid buying the same stock. If you do experience a wash sale, the capital loss is disallowed by the IRS and included in the cost basis of the replacement stock. So, if you sell the replacement stock later, any taxable gain will be smaller, and any deductible loss will be larger. Also, the holding period of the new stock now includes the holding period of the original stock. As a result, when you sell the new stock, the gain may be taxed at lower long-term capital gains tax rates.
However, the IRS doesn’t like investors to use "manufactured" losses to claim tax breaks. If you sell a stock at a loss and quickly buy it back or keep investing in it after buying it back, the IRS generally won’t allow you to write off the loss on your federal tax return. Let me give you an example:
- Let’s say that you bought 50 shares of a fictional Seagull Technologies stock for $100 per share ($5,000), and its value dropped to $80 per share.
- You decided to sell all your shares for $4,000 which resultsat a loss of $1,000.
- However, two weeks later, the stock's value dropped further to $50 per share, and you see an opportunity to get a good deal. So, you buy back back 50 shares for $2,500.
- The bad news is that you cannot claim the $1,000 capital loss on your tax return for that year because the second purchase was a wash sale.
[It should be noted that people often take losses to offset same-year gains that can ultimately reduce capital gains taxes. Also, remaining losses can be deducted from ordinary income (up to $3,000) or carried over to the following tax year. This means that many people opt to sell securities at a loss to reduce taxable gains, a technique commonly known as tax loss harvesting.]
How do you avoid the wash sale rule? You have a few options:
- Hold off on repurchasing the same or very similar stock that you sold.
- If waiting 61 days isn't feasible, purchase a security that is not substantially identical to the one you recently sold. The problem with this option is that the term “substantially identical” hasn’t been defined by Congress or the IRS. So, what’s considered substantially identical will depend on the facts and circumstances of your transaction. The IRS does give some examples to help go by in Publication 550:
- Generally, stocks of one corporation are not considered substantially identical to those of another corporation.
- A corporation's bonds and preferred stock are usually not considered too similar to its common stock, unless the preferred stock can be turned into common stock, has the same voting rights, or is limited in the same way in terms of dividends, then it would be considered substantially identical.
- A wash sale exists if your spouse or a corporation you control purchases substantially identical stock within the wash sale rule 61-day period.
- Things can get a little complicated when it comes to ETFs that track the same index. Some experts suggest switching to an ETF that tracks a different index, such as a total stock market ETF.
While the wash sale rule applies to most securities including stocks and options, bonds, mutual funds, and exchange-traded funds (EFTs), they don’t currently apply to cryptocurrency. This is partly because the IRS classifies crypto as property, not a security, which means that you can claim the capital loss if you are selling crypto for a loss and immediately rebuying it. So, for the moment, crypto investors have a tax loophole known as the "wash sale rule crypto loophole."
I should also mention that the wash sale rule goes beyond taxable investment accounts. It can also come into play with retirement accounts. As an example, if you sell a security at a loss in your regular brokerage account and then buy the same or substantially similar security in your IRA within 30 days or after the sale, the wash sale rule becomes an issue. You might lose the ability to claim the tax loss on your current year's return and wouldn't be able to adjust the cost basis of the repurchased security in your retirement account.
The bottom line is always that before selling and repurchasing stocks that decreased in value, you should seek trusted advice experts who are knowledgeable about the tax implications involved. There are day traders that are willing to take a wash sale as part of an overall stock adjustment, but even that is rare.