According to Revenue Code Section 1091, a taxpayer may not sell an asset at a loss and subsequently repurchase the same, or nearly identical, security within 30 days of the sale date. If this occurs, the loss will not be permitted and added to the cost basis of the newly purchased security. If the Wash Sale Rules are not triggered again, there will be no tax benefit to the taxpayer until a further sale of that security in the future. For the purpose of determining future short-term or long-term capital gain/loss treatment, the newly purchased security will use the holding period of the preceding security that was sold. (Note: Wash Sale Rules do not apply to persons who work as securities dealers.)
Key Points
Refer section 1091 of the Revenue Code governs wash sales.
The wash-sale rule forbids selling a loss-making investment and replacing it with the same or a "substantially identical" investment within 30 days of the sale.
If you do have a wash sale, the IRS will not allow you to deduct the investment loss, thereby raising your taxes for the year.
Your broker will provide you a Form 1099-B to aid in the preparation of your personal income tax returns for the year. This form normally reports disallowed losses incurred over the year as a result of Wash Sale Rules.
Avoid misunderstandings. It is crucial to note that selling ABC Stock for a loss in one brokerage account and then repurchasing ABC Stock within 30 days from a separate brokerage account would still result in a Wash Sale, but you will have to keep track of this information manually this time.
Basis - the disallowed loss INCREASES the cost basis of the freshly purchased stock or option that prompted the wash sale.
Holding period - the holding time for a new stock or option begins on the same day that the securities are sold.
What is the wash-sale rule?
You can obtain a tax break if you sell a losing investment in a taxable account. The wash-sale rule prohibits investors from selling at a loss, then repurchasing the same (or "nearly identical") stock within 61 days and receiving the tax benefit. It applies to the majority of investments that could be held in a regular brokerage account or IRA, such as equities, bonds, mutual funds, exchange-traded funds (ETFs), and options.
The wash-sale rule stipulates that if you buy the same security, a contract or option to buy the security, or a "substantially identical" asset within 30 days before or after the date you sold the loss-generating investment (a 61-day window), the tax loss will be rejected.
It is crucial to remember that you cannot avoid the wash-sale rule by selling an investment at a loss in a taxable account and then reinvesting the proceeds in a tax-advantaged account.
Furthermore, the IRS has stated that a stock sold at a loss by one spouse and purchased inside the restricted time period by the other spouse is a wash sale. Consult your tax professional about your specific situation.
How to avoid a wash sale?
Consider replacing a mutual fund or an exchange-traded fund (ETF) that targets the same industry to prevent a wash sale on an individual stock while still retaining your exposure to the industry of the stock you sold at a loss.
When selling a stock at a loss, ETFs can be very useful in avoiding the wash-sale rule. Unlike ETFs that track broad market indexes such as the S&P 500, some ETFs track a specific industry, sector, or other subset of companies. These ETFs can be useful for regaining exposure to the industry or sector of a stock that you have sold, but they normally include enough securities to pass the test of not being substantially identical to any specific stock.
Due to the substantially identical security criterion, swapping an ETF for another ETF, a mutual fund for another mutual fund, or even an ETF for a mutual fund can be more difficult. There are no definitive rules defining what defines a substantially comparable security. The IRS decides whether your transactions are in violation of the wash-sale regulation. If this occurs, you may end up paying more taxes than you intended for the year. When in doubt, seek the advice of a tax specialist.
What is the wash-sale penalty?
What happens if the IRS concludes that your transaction was a wash sale?
The selling loss cannot be used to offset gains or reduce taxable income. However, your loss is added to the new investment's cost base. The holding term of the previous investment is added to the holding duration of the new investment. In the long run, a greater cost basis may have an advantage—you may be able to recoup a larger loss when you sell your new investment, or if it rises and you sell, you may owe less on the gain. The longer holding time may enable you to qualify for the lower long-term capital gains tax rate rather than the higher short-term capital gains tax rate.
A letter from the IRS stating that a loss is not allowable is never good, therefore it's wise to read, understand the wash sale concept. If you're concerned about purchasing a potential replacement investment, wait at least 30 days after the sale date. Alternatively, take help from a financial professional who should be able to comfortably handle the intricacies of taxes and investing.
See IRS Publication 550 for further information.
