Understanding Wash Sales: A Comprehensive Guide for Investors

You may have sellers remorse in a down market. Or perhaps you’re attempting to profit from some losses without losing a worthwhile investment. In any case, it’s crucial to refrain from making a “substantially identical” investment 30 days prior to or 30 days following the sale date if you sell an investment at a loss. Breaking the so-called wash-sale rule can result in an unforeseen tax bill.

What is a Wash Sale?

A wash sale occurs when an investor sells a security at a loss and then repurchases the same or a substantially similar security within a 60-day window, which includes 30 days before and 30 days after the original sale. This rule, implemented by the Internal Revenue Service (IRS), prevents investors from claiming capital losses on securities they intend to repurchase shortly after selling them, essentially negating the loss and using it to reduce their tax liability

How the Wash Sale Rule Works

Let’s break down the key aspects of the wash sale rule:

  • Timeframe: The 60-day window is crucial. If you repurchase the same or a similar security within this timeframe, the IRS considers it a wash sale, and the loss is disallowed.
  • Substantially Similar Securities: This includes not only the same security but also any security that is considered highly similar in terms of its characteristics and risk profile. For example, selling one stock in a particular sector and immediately buying another stock in the same sector could be considered a wash sale.
  • Loss Disallowance: The disallowed loss cannot be claimed against your taxable income in the current year. However, the loss is not entirely lost. It is added to the cost basis of the newly purchased security, effectively increasing its cost and reducing any future taxable gains when you sell it.

Example of a Wash Sale

Imagine you own 100 shares of ABC stock, which you purchased for $10 per share. The stock price falls to $8 per share, and you decide to sell your shares to realize a $200 loss ($100 x 2). However, you immediately repurchase 100 shares of ABC stock at $8 per share. This transaction triggers a wash sale, and the $200 loss cannot be claimed on your tax return. Instead, the $200 loss is added to the cost basis of the newly purchased shares, increasing it to $10 per share.

Special Considerations

  • Bonds and Preferred Stock: The IRS generally does not consider bonds and preferred stock of an issuing company to be substantially identical to the company’s common stock. However, exceptions exist, such as when preferred stock is convertible into common stock without restrictions, has the same voting rights as common stock, and trades at a price close to the conversion ratio.
  • IRA Transactions: Wash sales can also occur within Individual Retirement Accounts (IRAs). If you sell shares in a non-retirement account and repurchase substantially identical shares in an IRA within 30 days, the loss is disallowed, and the basis in your IRA is not increased.

Reporting a Wash Sale Loss

While the loss from a wash sale cannot be claimed in the current tax year, it is not entirely lost. The disallowed loss is added to the cost basis of the newly purchased security, reducing your taxable gains when you eventually sell it. This effectively defers the tax benefit of the loss to a future tax year.

Avoiding Wash Sales

To avoid triggering a wash sale, ensure that you wait at least 31 days before repurchasing the same or a substantially similar security after selling it at a loss. Alternatively, consider selling a different security in the same sector or diversifying your portfolio by investing in a different asset class.

Understanding the wash sale rule is crucial for investors who want to optimize their tax strategies. By being mindful of the 60-day window and the concept of substantially similar securities, you can avoid triggering wash sales and maximize the tax benefits of your investment decisions. Remember to consult a tax professional for personalized advice regarding your specific situation.

What is the wash-sale rule?

You may receive a tax benefit when you sell an investment in a taxable account that has lost money. The wash-sale rule prohibits investors from making a loss on a sale, repurchasing the same investment within 61 days, and then claiming the tax benefit. The majority of the assets you could have in an IRA or standard brokerage account, such as stocks, bonds, mutual funds, exchange-traded funds (ETFs), and options, are covered by it.

In particular, the wash-sale rule stipulates that if you purchase the same security, a contract or option to purchase the security, or a “substantially identical” security within 30 days of selling the loss-generating investment, you will not be able to claim the tax loss (there is a 61-day window for this).

It is crucial to understand that selling an investment at a loss in a taxable account and then purchasing it back in a tax-advantaged account is not an option to circumvent the wash-sale rule. Additionally, the IRS has declared that it considers a stock sale by one spouse at a loss to be a wash sale if the other spouse purchases the stock within the restricted period. Check with your tax advisor regarding your personal situation.

How to avoid a wash sale

Using a mutual fund or exchange-traded fund (ETF) that focuses on the same industry as the stock you sold at a loss is one way to avoid a wash sale on that particular stock while keeping your exposure to that industry.

ETFs are especially useful when trying to sell a stock at a loss because they can help avoid the wash-sale rule. As opposed to ETFs that concentrate on broad-market indexes, such as the S Though these exchange-traded funds (ETFs) typically hold enough securities to pass the test of not being substantially identical to any individual stock, they can be a convenient way to regain exposure to the industry or sector of a stock you sold.

Because of the substantially identical security rule, switching an ETF for another ETF, a mutual fund for another mutual fund, or even an ETF for a mutual fund, can be a little more difficult. What defines a substantially identical security is not well defined. The IRS determines if your transactions violate the wash-sale rule. Should that occur, you might have to pay more taxes overall than you had budgeted for the year. So when in doubt, consult with a tax professional.

Understanding a Wash Sale | Fidelity Investments

FAQ

How do I avoid a wash sale?

To avoid a wash sale, the investor can wait more than 30 days from the sale to purchase an identical or substantially identical investment or invest in exchange-traded or mutual funds with similar investments to the one sold.

What is the penalty for a wash sale?

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.

What is an example of a wash sale?

An additional 100 XYZ Company shares for $39 per share at 11:30 a.m. On September 6, you sell 100 XYZ Company shares at $35 per share. This would result in a wash sale because you purchased the identical security in two separate transactions on August 15th and sold some of those shares at a loss within 30 days.

Can I sell a stock for a loss and buy it back?

A wash sale occurs when an investor sells a security at a loss and then purchases the same or a substantially similar security within 30 days, before or after the transaction. This rule is designed to prevent investors from claiming capital losses as tax deductions if they re-enter a similar position too quickly.

What happens if I trigger a stock wash sale?

If you trigger the wash sale rule, whether intentionally or unintentionally, the IRS won’t allow you to claim that loss on your taxes in current or, if it’s large enough, future years. If you were counting on that to offset your capital gains or reduce your taxable income, you may end up owing more taxes than you expect.

What is a stock wash sale?

A wash sale is categorized when an investor sells a stock or security and repurchases the same or a substantially identical security within 30 days of the sale. The US Internal Revenue Service (IRS) introduced the 61-day wash sale rule to prevent investors who hold unrealized losses from benefiting from a tax deduction.

How long do I have to wait before I can repurchase a stock after triggering a wash sale?

You can avoid violating wash sale rules in several ways. First, you should allow at least 30 days to pass after selling a stock before purchasing it again. The other option is to purchase a similar stock instead of the same stock.

Are there any tax implications of a stock wash sale?

The IRS considers this to be a “sale” for tax purposes, but not for investment purposes. As a result, you can’t deduct the loss on your taxes. Wash sales are relatively common, especially among traders who frequently buy and sell stocks.

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