Part of investing is managing your gains and losses wisely, hopefully by minimizing your taxable gains and maximizing your losses. Understanding the wash sale rule and how it impacts your investment strategy can keep you from accidentally reporting your losses incorrectly.

What happens when you sell stocks in your taxable investment accounts? Simply put, you will typically incur taxable gain if you sell a holding at a price higher than the purchase price, and you will incur a taxable loss if you sell it at a lower purchase price. The resulting gain or loss is called capital gain or capital loss. 

The IRS generally allows you to offset any capital gain by the amount of capital loss you incur, resulting in lower taxable gain, and hence, lower taxable income. Note that capital gains taxes do not apply to retirement accounts.

For example, if you purchased ABC stock for $100 and later sold it for $150, you would recognize a taxable capital gain of $50 at the time of sale. If you also purchased XYZ stock for $200 at the same time you purchased ABC stock and later sold the XYZ stock for $150 as well, you would incur a capital loss of $50 on the XYZ stock. Theoretically, when you filed your tax return you would receive a tax deduction for the $50 capital loss on XYZ stock and owe tax on the $50 gain on ABC stock. However, you would actually end up not owing any tax at all because the $50 loss on XYZ would offset the $50 gain on ABC ($50 – $50 = $0). You effectively have a wash.

In the example above, if you had sold your XYZ stock for $150 and then purchased more shares within 30 days of selling, you would not be permitted to deduct the $50 loss incurred from the sale of the original shares. This is known as a wash sale and the loss is disallowed by the IRS.

What is a wash sale? 

The IRS defines a wash sale as occurring when you sell or trade stock or security for less than the amount you paid for them and then purchase the same or “substantially identical” stock or securities within 30 days before or after the sale. 

A wash sale applies if you:

• Obtain the same or substantially identical stock or security as part of a trade that is considered taxable by the IRS.
• Obtain a contract or an option that allows you to purchase the same or substantially identical stock or security.
• Purchase or obtain the same or substantially identical stock or security within your traditional or Roth IRA. In other words, if you sell a holding in your brokerage account and then buy it back in your IRA to avoid the wash sale, you still will not be permitted to deduct the loss, as the rule applies to all of your accounts in aggregate, including any additional brokerage accounts you may have.

The overall timeframe for the wash sale rule is 61 days, which includes 30 days before the sale, the day of the sale, and 30 days after the sale. 

The rule is designed to prevent investors from selling their stocks or securities at a loss when the price drops to less than they paid, and then purchasing the same or substantially identical investments at a lower price within this 61-day window. 

If the wash sale rule were not in place, investors would be able to receive the benefit of a tax deduction for the loss on the sale while still maintaining a position in the same or substantially identical stock or security. 

The wash sale rule applies to most of the investments you are permitted to include in a taxable brokerage account or Individual Retirement Account (IRA). These include individual stocks and bonds, mutual funds, exchange-traded funds (ETFs), and options to buy or sell stock or securities. Cryptocurrency, commodities futures contracts, and foreign currencies are not subject to the wash sale rule under current tax law, however, that may change.

It should also be noted that if you are considered a professional dealer in stocks and securities under IRS guidelines and you incur a loss from a sale as part of your ordinary course of business, the wash sale rule will not apply. This means that you will be permitted to deduct losses incurred within the 61-day window.

What is “substantially identical”?

IRS guidance on “substantially identical” is not crystal clear and is somewhat open to interpretation. The IRS will ultimately have the final determination as to what constitutes “substantially identical”. However, the IRS does provide the following guidelines for determining what is and isn’t considered “substantially identical.”

• Stocks and securities of one corporation are not considered substantially identical to the stocks and securities of another corporation. For example, stock in Apple is not substantially identical to Amazon stock. They are two separate companies. However, if two corporations were to go through a reorganization, the stocks and securities of the original company and the new company could possibly be considered substantially identical.

• Preferred stock or bonds of a corporation are typically not considered substantially identical to the common stock of that same company. If the preferred stock or bonds are able to be converted into common stock of the company, however, this feature could cause the preferred stock and bonds to be considered substantially identical to the common stock. Specifically, if the convertible preferred stock has the same voting rights as the common stock, is subject to the same restrictions on dividends, trades at prices that do not significantly vary from the conversion ratio, and has no restrictions on its convertibility, then the preferred and common stock of the same corporation will be considered substantially identical.

All is not lost 

On the surface, it may seem as though the wash sale rule prevents you from claiming losses when sales are executed within the 61-day window. However, this is not the case. Triggering the wash sale only defers, not eliminates, the deduction of the loss.

If you trigger a wash sale, the amount of loss that is not deductible will be added to the cost of the newly purchased, substantially identical stock. This means that if you later sell the newly purchased stock at a gain, you will pay less in taxes. Similarly, if you later sell the stock at a loss, you will receive a larger tax deduction.

For example: If you were to purchase 100 shares of ABC stock for $1,000 and later sold them for $600, you would normally incur a $400 loss that you could deduct on your income tax return. However, if you purchased 100 new shares of ABC or substantially similar stock for $800 within 30 days of selling the original 100 shares, you would not be able to deduct the $400 loss. Instead, you would be permitted to add the $400 to the cost of your new shares, increasing the cost basis of these shares from $800 (actual purchase price) to $1,200 ($800 purchase price + $400 loss). If you later sold these new shares for $1,500, your taxable capital gain would be $300 ($1,500 – $1,200) rather than $700 ($1,500 – $800). 

Alternatively, if you sold the shares for $700, you would incur a $500 loss ($700 sale price – $1,200 adjusted cost basis), versus the $100 loss ($700 sale price – $800 original cost) you would have realized had the initial $400 loss not been added to the cost of the substantially identical shares that triggered the wash sale. 

Effectively, you would simply be deferring the loss deduction until you sold the newly acquired shares that triggered the wash sale. Additionally, the holding period for your new shares would include the holding period of the original shares that were sold. 

To illustrate, assume you owned the original shares of ABC stock noted above for 2 years prior to selling them. You decided to sell the newly purchased substantially identical shares at a gain only 8 months after purchase. Normally, a sale made within 1 year or less of purchase would be considered short-term and a higher income tax rate would apply. However, since the holding period for the new shares would include the holding period of the original shares, the total gain would be treated as long-term (2 years + 8 months), which would be assessed a lower tax rate under current law.

Stock grants are also subject to wash sales

If you are granted shares of your employer’s stock as part of an incentive pay plan, you would report the fair market value of the stock on the grant date as part of your gross income. If you later sold the shares at a loss and your employer granted you another award of the stock within 30 days of the sale, the wash sale would be triggered and you would not be permitted to deduct the loss.

Wash sales are reported annually with your tax return on IRS Form 8949. For additional details and examples of wash sales, refer to IRS Publication 550, Investment Income and Expenses.

Looking for an independent fiduciary financial advisor who can advise you on investments, retirement, real estate, alternative assets, and taxes? Contact ACap Advisors & Accountants to schedule a free initial consultation. Our clients include individuals, small businesses, entrepreneurs, and anyone serious about saving and investing for their future.