The Wash Sale Rule of Capital Gains Tax

THE WASH SALE RULE OF CAPITAL GAINS TAX

The Wash Sale Rule of Capital Gains Tax

Awash sale is a trading activity in which shares of a security are sold at a loss and substantially identical security is purchased within 30 days. The subsequent purchase could occur before or after the security is sold, creating a 61-day window that must be monitored to identify wash sales.

IRS Explanation of Wash Sales

The IRS defines a wash sale as “a sale of stock or securities at a loss within 30 days before or after you buy or acquire in a fully taxable trade, or acquire a contract or option to buy, substantially identical stock or securities.”  The wash sale rule for gains under Section 1091 of the Internal Revenue Code (IRC) is intended to prevent investors from generating and recognizing artificial losses in situations where they do not intend to reduce their holdings in the securities that are sold.

For purposes of Section 1091 wash sales occur when an investor realizes a loss on the sale of a security and the investor acquires a “substantially identical” security within a 61-day “window” that extends from 30 days before the date of the sale to 30 days after the date of the sale.  If an investor sells the stock at a loss, and then buys a “substantially identical” replacement stock within this 61-day window, a wash sale holding period occurs and the loss is deferred until the replacement shares are sold.

The pro rata loss is added to the cost basis of the replacement shares purchased, and the holding period of the replacement shares includes the holding period of the original shares sold. However, the deferred loss will eventually be recognized when the replacement shares are sold.  For more information about the IRS and the wash sale rule, please see IRS Publication 550.

Wash Sale Example

An investor buys 100 shares of Yahoo stock for $5,000 on October 1. On December 7 the investor sells these 100 shares of Yahoo stock for $4,500. On December 16 the investor buys 100 shares of Yahoo for $4,750. Because the investor bought substantially identical stock within 30 days of the sale of Yahoo, a wash sale occurred and the loss of $500 on the sale of Yahoo cannot be deducted. The loss is deferred and applied to the cost basis of the new tax lot. Therefore, the wash sale in this example would raise the cost basis of the new lot from $4,750 to $5,250.

If you sell a stock and your spouse (if filing jointly) or a corporation you control buys a substantially identical stock, you also have a wash sale. In these cases, the IRC states that losses from the sale of stock can not be recognized at the time of sale, but must be deferred instead.

Wash sales can span tax years. For example, if you sold a stock for a loss in December and repurchased the stock the following January you would have a wash sale replacement shares. For this reason, it is important to include all January trades when calculating your capital gains for Schedule D.

What the Wash Sale Rule Really Means to Investors

If you are active in a particular stock, it is imperative that you monitor your wash sales period before you re-purchase the stock. After you have taken a loss, you need to be aware of the date you can repurchase security and still claim the earlier loss on taxes. Investors may find themselves not being able to realize significant losses due to wash sales.

Manually tracking the wash sale periods or using a portfolio service such as Gains Keeper that can account for wash sales, will prevent you from purchasing the stock in a wash sale period. Nothing is more frustrating than selling stock at a loss to offset your tax bill only to find out after January 1st that a wash sale disallowed the loss.

While you will eventually realize losses deferred by wash sales, avoiding them in the first place will help you maximize your investment performance.

How to Avoid Wash Sales

Wash sales can be avoided by waiting to repurchase replacement shares until after the 30-day window closes.

You can also avoid a wash sale by purchasing similar security, rather than an identical stock, to the one you sold for a loss. For example, if you sold Yahoo for a loss and you were interested in investing in another portal stock, then you could buy Google within the 30-day window and not trigger a wash sale.

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Alan Olsen, CPA

Alan Olsen, is the Host of the American Dreams Show and the Managing Partner of GROCO.com.  GROCO is a premier family office and tax advisory firm located in the San Francisco Bay area serving clients all over the world.

 

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