You may have seller’s remorse in a down market. Or you may be trying to capture some losses without losing a great investment. However it happens, when you sell an investment at a loss, it’s important to avoid replacing it with a “substantially identical” investment 30 days before or 30 days after the sale date. It’s called the wash-sale rule and running afoul of it can lead to an unexpected tax bill.
What is the wash-sale rule?
When you sell an investment that has lost money in a taxable account, you can get a tax benefit. The wash-sale rule keeps investors from selling at a loss, buying the same (or “substantially identical”) investment back within a 61-day window, and claiming the tax benefit. It applies to most of the investments you could hold in a typical brokerage account or IRA, including stocks, bonds, mutual funds, exchange-traded funds (ETFs), and options.
More specifically, the wash-sale rule states that the tax loss will be disallowed if you buy the same security, a contract or option to buy the security, or a “substantially identical” security, within 30 days before or after the date you sold the loss-generating investment (it’s a 61-day window).
It’s important to note that you cannot get around the wash-sale rule by selling an investment at a loss in a taxable account, and then buying it back in a tax-advantaged account. Also, the IRS has stated it believes a stock sold by one spouse at a loss and purchased within the restricted time period by the other spouse is a wash sale. Check with your tax advisor regarding your personal situation.
How It Works
Generally, a wash sale has three parts.
- An investor notices they are in a losing position, so they close it by selling the stock or exiting a trading position.
- The sale allows them to take a loss that they can legally claim on their tax returns as a reduction of their earnings for that year, which reduces their total tax liability.
- The investor will look to purchase the security at or below the price at which they sold it—if the purchase occurred 30 days before or after the sale, it is considered a wash sale, and the loss cannot be claimed.
Wash Sale Example
Assume an investor has a $15,000 capital gain from the sale of ABC stock. They fall in the highest tax bracket and must pay a 20% capital gains tax of $3,000. But let’s say they sold XYZ security for a loss of $7,000. The net capital gain for tax purposes would be $15,000 – $7,000 = $8,000, which means they’ll have to pay only $1,600 in capital gains tax. Notice how the realized loss on XYZ reduces the gain on ABC, reducing the investor’s tax bill.
However, if the investor repurchases XYZ stock—or a stock substantially identical to XYZ—within 30 days of the sale, the above transaction is counted as a wash sale, and the loss is not allowed to offset any gains.
The IRS does not ordinarily consider bonds and preferred stock of an issuing company to be substantially identical to the company’s common stock. However, there may be circumstances where preferred stock, for example, may be considered substantially identical to the common stock.
This would be the case if the preferred stock is convertible into common stock without any restriction, has the same voting rights as the common stock, and trades at a price close to the conversion ratio.
Reporting a Wash Sale Loss
The good news is that any loss realized on a wash sale is not entirely lost. Instead, the loss can be applied to the cost basis of the most recently purchased substantially identical security. Not only does this addition increase the cost basis of the purchased securities, but it also reduces the size of any future taxable gains as a result.
Thus, the investor still receives credit for those losses, but at a later time. Also, the holding period of the wash sale securities is added to the holding period of the repurchased securities, which increases an investor’s odds of qualifying for the 15% favorable tax rate on long-term capital gains.
Are Wash Sales Illegal?
A wash sale is not illegal—there is no wording that states you cannot sell a security and purchase a substantially similar one 30 days before or after the sale. The rule only makes it so you can’t claim a loss on the sale in that year’s tax filing.
Is a Wash Sale 30 or 60 Days?
A wash sale is a 60-day window—from 30 days before the sale to 30 days after the sale.
How Do I Avoid a Wash Sale?
If you have sold or intend to sell a security at a loss, you can avoid triggering the wash sale rule by purchasing a similar instrument 31 days or more before or after the sale.
Same Stocks vs. or Substantially Identical Stocks
When determining the transactions that are counted as wash sales, the IRS uses the terms “same stocks” or “substantially identical stocks” to determine if investors are claiming artificial losses. Two securities are identified as the same if they are exactly identical or if they share most of their characteristics.
A company’s bonds and preferred stock are considered different from the same company’s common stock. Also, the securities of one company, e.g., ABC Company, are not identical to the stocks of another company, e.g., XYZ Company.