What Is The Wash-Sale Rule?
A wash sale occurs when a trader buys and sells the same stock, or substantially similar security in order to claim a loss within 30 days.
How Does Wash Sale Occur?
Wash sale occurs in one of the two ways mentioned below.
- A substantially identical security is purchased or sold within 30 days before or after the sale of original security.
- A substantially identical security is purchased or sold at a price that’s less than the price paid for another substantially identical security within 30 days before or after the sale of original security.
Note: According to Internal Revenue Service (IRS) regulation, a wash sale also occurs if an individual sells stocks and the individual’s spouse or a company controlled by the individual purchases substantially equivalent security during the 61-day wait period. As the individual is essentially selling the security to themselves in order to claim the loss on their taxes, investors consider this as a form of tax avoidance.
What Is The Purpose Of Wash Sale Rule?
The purpose of the wash sale rule is to discourage investors from selling securities at a loss and then immediately buying them back so that they can claim the loss on their taxes.
Under the wash sale rule, investors are not allowed to deduct the loss from the sale on their taxes, if they buy the “same stock” or “substantially identical security” within 30 days. The wash sale rule is applicable to bonds, stocks, and other securities.
Therefore, the wash sale rule is intended to prevent investors from selling securities at a loss and then immediately procuring the same or substantially similar securities. If an investor were allowed to claim a loss on the sale of a security and then immediately claim a gain on the repurchase of the same security, the investor would be able to deduct the loss while essentially maintaining the same position. The wash sale rule prevents investors from claiming a loss on the sale of a security if the investor purchases the same or substantially similar security within 30 days before or after the sale.
Things to keep in mind:
- The wash sale rule solely applies to losses, not gains.
- The rule applies to securities that are “same” or “substantially similar.”
- The rule applies to a wash sale that occurs within 30 days before or after the sale of the security.
- The rule applies to both open market transactions and transactions involving derivatives.
- The rule does not apply to losses incurred in foreign currency transactions
- The rule can be complex, and investors should consult a tax advisor if they have questions
How Does The Wash-Sale Rule Work?
The Wash-Sale Rule applies to losses on the sale or exchange of securities, including stocks, bonds, or other identical security. The prime intent of the wash sale rule is to disallow the deduction of losses on the sale or exchange of securities if the same or substantially identical securities are purchased within 30 days before or after the sale or exchange.
Time Frame of Wash Sale Rule
Generally, the timeframe for wash sale rule is 61 days i.e., if you buy and sell a security within a 61-day period, you cannot deduct your loss on the transaction for same or similar security. For example, if you bought shares of Apple stock, and then decided to sell those shares at a loss, you would not be able to claim an additional loss on another Apple stock purchase within 30 days of your initial sale.
In addition, the wash-sale rule is not just limited to stocks. If you sell and buy back the same contract or identical options within a 30-day timeframe, you will also be subject to the wash-sale rule.
Can IRA Transactions Trigger The Wash-Sale Rule?
Yes, IRA transactions can also trigger the wash-sale rule. Revenue Ruling 2008-5 states that when shares are sold in a non-retirement account and identical shares are purchased in an IRA within 30 days, the investor cannot claim tax losses for the sale.
Wash-Sale Rule Example
In order to understand how wash sales work, let’s take a look at an example.
Let’s assume, you buy 100 shares of ABC stock for $1,000 on January 1st. You then sell those 100 shares on February 2nd for $800. If you bought another 100 shares of ABC stock on February 5th for $800, you would not be able to deduct any loss because the purchase and sale happened within 30 days of each other.
Therefore, if someone sells some securities and then buys them back within 30 days of selling them, it is called a ‘wash sale’ and is not allowed by the IRS (Internal Revenue Service). IRS introduced this rule to prevent investors from manipulating their taxes by claiming losses that are actually profits from another trade.
Note: Wash sale rule is a tax law that disallows you from realizing a loss for the same security within the given time frame. The IRS says that wash sales can be found in cases where a taxpayer sells a security at a loss, and then purchases it back immediately or within 31 days, and then sells it again at a profit. The government claims that as an artificial transaction and constitutes it as prohibited under Section 1091 of the Internal Revenue Code and seeks to disallow any losses incurred by taxpayers who engage in this behavior.
Special Considerations:
Substantially Identical Securities: The first step in determining whether a wash sale has occurred is to identify the security being sold and then find its corresponding purchase. IRS uses the term “same stocks” or “substantially identical securities” to determine if investors are claiming artificial losses. The IRS has provided a list of factors that are considered when determining whether two securities are substantially the same. These include:
- The issuer of each security is the same;
- The nature of each security is similar;
- The maturity date of each security is similar;
- The classifications and ratings assigned to each security by an independent rating agency are the same;
- Each security has a principal place of business in the same state or country; and
- The stated interest rate on each security is similar (or there is no stated rate for one of them).
Cost Basis Change
If there is a difference in price between the first purchase and all later purchases, there may be an opportunity for potential tax savings by claiming a loss on one or more of your later purchases, which becomes the cost basis for the new stock.
Suppose, the cost basis for 100 shares of Stock ABC, which is trading for $100 per share. To hedge your position, you sell short 100 shares of stock ABC at $100 per share. The next day, Stock ABC rises to $110 per share and you decide to buy back 100 shares of stock ABC at $110 per share. This is considered as a wash sale and IRS will not allow you to claim the loss on your taxes because it considers the two trades as one trade.
Cryptocurrency Losses
The Internal Revenue Service (IRS) has not yet issued an official position on the tax treatment of cryptocurrencies. However, it is likely that these transactions will be treated as “property” rather than “currency” for federal income tax purposes.
If you’re a cryptocurrency investor, you may be able to offset your losses with gains from other transactions. For example, if you have a stock that loses value but then rebounds, and you sell it for a profit, you can use your cryptocurrency losses to offset that gain. This is because transactions related to cryptocurrency are not subject to the wash-sale rule. They are considered property at this time by the IRS. Cryptocurrencies have not been designated as securities hence, they are exempt from these restrictions on how losses can be claimed on tax returns.
Note: The classification of cryptocurrency is irregular. If you’re not sure how this works or what constitutes a “loss,” check with an appropriate financial advisor before engaging in any transactions for tax harvesting purposes.
Ways To Avoid The Wash-Sale Rule
The wash-sale rules prevent taxpayers from profiting on losses. While this is a good thing, it can be a bit of a headache if you don’t understand how to get around the rule. Here are a few ways to avoid the wash sale rule.
- Investors often realize that they want to keep a similar position in a particular sector after selling their holdings. For example, ABC tech stock. To do this, they can sell their ABC stock and use the proceeds to buy a tech exchange-traded fund (ETF) or tech mutual fund. Although this strategy does not entirely replicate the original position, but it allows investors to continue holding a position in the technology sector even if they no longer own ABC stock. When the wash sale period has passed, you can sell the fund or ETF and then repurchase your ABC stock (if you wish).
- Second, if you want to offset gains with losses for tax purposes, but don’t want to own the stock any longer, selling all of it is not a good idea because it will result in a capital loss that cannot be used against other gains. Instead, buy additional shares (at least as many as you sold) right away. This way you can still be in the market if things improve down the road. At the end of 30 days, you can sell your entire position (at a loss), which will offset all previous gains and reduce your tax liability on any other gains from that year.
- If you own a stock, but wish to sell it before the wash-sale rule wait period ends, consider buying a call option on the same stock. If the price of the stock rises, you can sell your call option and use that profit to offset any losses from selling your shares. This will keep you in the market while avoiding the wash-sale rule, and allow you to collect your loss when the waiting period ends.
- If you believe that a stock’s price will go up, then selling some of your shares and leaving the rest in place is a good strategy. If you sell all your shares, then you’ll have to wait 30 days before buying more. With this strategy, you will have a tax-deductible loss and still maintain a position in the stock you believe may appreciate in value.
How Do I Benefit By Understanding Wash Sales?
Wash sales have important tax implications, and it is important for investors to understand how they work.
- Investors can receive tax deductions or claim a loss that is allowed
- Investors can work with the wash sale rule’s waiting period and comply with important end-of-year tax dates
- After selling their initial position, investors can purchase appropriate stocks or related securities to maintain the position they are expecting
- Investors can avoid violating the wash sale rule
- Avoid repercussions of breaking the rule while staying in the market
- Investors should consult with a tax professional to ensure that they are in compliance with the rule and to know when the rule has no impact on your transactions