Taxes are statutory deductions that an individual and organization pay to the government. Taxes generate revenue for running the government. If taxpayers evade tax, it must be within the ambit of the law.
A Wash Sale is a wealth management practice to take advantage of harvesting tax losses to reduce taxes. To prevent investors who hold unrealized losses from benefiting from a tax deduction, the IRS (Internal Revenue Service) introduced the 61-day wash sale rule. (i.e., 30 days before the loss, the day of the loss, and 30 days after the loss).
Wash Sale
A wash sale transaction is when an investor sells a stock or security and repurchases the same or substantially identical stock within 30 days of the sale. This rule holds when an investor or business sells an asset, such as a stock or bond, for a loss but has purchased the same or similar asset within 30 days before or after the sale.
Wash Sale Rule
The wash sale rule prohibits an investor from deliberately harvesting losses to gain a tax advantage. If an investor sells a security at a loss and repurchases the same or a substantially identical one within 30 days before or after the sale, he stands getting checked by the rule.
The rule prevents investors from creating an investment loss for the benefit of a tax deduction while maintaining the same or similar position in the security.
The rule is to disallow bad faith investors from using temporary dips in an investment’s value to secure a tax break and then turn around and repurchase the same investment to lock in a better cost basis on which they will calculate all future taxes on gains. A wash sale comprises two transactions: the sale of a security at a loss and the repurchase within 30 days.
Suppose an investor purchases the same or substantially identical security within the 61-day time frame. In that case, the IRS effectively ignores the transaction, and the investor adds the loss amount to the replacement security cost. However, it defers the loss until the investor sells the replacement security.
Conditions for Wash Sale Transaction
- If the sold and the purchased stocks are identical, they are from the same company. E.g., Microsoft stock and Microsoft options. Stocks or securities of different corporations are not considered substantially identical except in a reorganization.
- Repurchase of earlier sold stock within 30 days with the hope of regaining the value of the security.
- If an investor sells stocks followed by the purchase of the same by his spouse or a corporation he controls.
Exceptions of Wash Sale Rule
- The wash sale rules do not apply to a dealer in stock or securities if the loss is from a transaction made in the ordinary business.
- They do not apply to losses from sales or trades of commodity futures contracts and foreign currencies.
Wash Sale Rule Example
Mr. John buys 1,000 shares of Apple Inc. for $120,000. He sells these shares for $110,000, and within 30 days of the sale, he buys another 1,000 shares of Apple’s stock at a higher price and maintains his position in the same stock.
Because he had bought the identical stock, he could not deduct the loss of $10,000 on the sale.
The initial loss is not a tax loss as the investor purchased the same stock within 30 days of the sale of the same stock as per the Wash Sale rule. However, this loss will be added to the purchase and decide the tax gain or loss when the investor sells the stock.
Avoiding the Wash Sale Rule
Certain considerations can help avoid triggering the rule. These includes:
- Wait 30 Days: Waiting to buy the same, or a similar, investment for the full 30-day period after selling an investment is the surest way to avoid a Wash Sale.
- Find Materially Different Investment(s): While the IRS rule on what constitutes “substantially identical” is not crystal clear, the bottom line is that government does not want investors getting a tax break for something that is not a loss for them. So, for example, to be extra careful, an individual investor or business can be certain that they will avoid the wash sale rule if they invest in a completely different industry or sector.
- Develop an Investment Plan: Investors unprepared for short-term market downturns may accidentally trigger the Wash Sale rule if they panic sell and then rebuy the same investment once the market starts recovering. A long-term investment plan that they stick to, even during market downturns, can help businesses make the best investing and tax decisions for good and bad times.
Wash Sale Rule FAQs.
What is the Penalty for the Wash Sale Rule?
There is no penalty under Wash Sale Rule, but you cannot use the loss on the stock sale to offset gains or reduce taxable income. Instead, you will add the loss to the cost basis of the new investment.
Is a Wash Sale 30 days or 30 Trading Days?
It is 30 calendar days, not trading days. The Wash Sale period for any sale at a loss consists of 61 days: the day of the sale, 30 days before, and 30 days after the sale.
Is Wash Sale a crime?
A wash sale is not a crime; sometimes, claiming the tax loss on a wash sale can be illegal. It will disallow the losses on any sales made within 30 days before or after the purchase.
Conclusion
The Wash Sale rule states that investors cannot deduct losses from sales or trades of stock or securities in a wash sale unless they incurred the loss in the ordinary course of their business as a dealer in stock or securities.
The rule keeps investors from selling at a loss, repurchasing the same investment within a 61-day window, and claiming the tax benefit. It applies to most investments held in a typical brokerage account, including stocks, bonds, mutual funds, exchange-traded funds (ETFs), and options. If the rule applies to a business, it will mean that it may end up paying more taxes for the year than anticipated.
Due to the applicability of the wash sales rule’s complexity, it is always good to consult a tax professional when in doubt.