The Wash-Sale Rule Explained

You wouldn’t stop playing baseball just because you aren’t the one batting, right? Likewise, the right minds never believe the game to be over simply because a stock’s value plummeted overnight. 

Deducting losses on taxable income from an underperforming stock is popular with investors. Selling off a bad investment at a loss to minimize the capital gains in your portfolio is a rather big brain move. However, encountering its boomerang effect can appear as a rather rude awakening.

Imagine a situation where an investor is offered double the shares expected in a brand-new, prospective offering. Let’s say, he now has 1000 at PepsiCo at $50 each. A week later, these shares tumbled to $40. Now, he has an opportunity to seize the $10,000 capital loss and eventually repurchase the stock. 

Should the repurchase happen immediately, the tax-loss harvesting becomes self-defeating. The capital loss earned will be negated and ultimately adjusted to the cost basis of the new purchase. This could possibly sound like make-believe sorcery, but the IRS Publication 550 disagrees.

Enter the Wash-Sale Rule: the game-changer protecting the tax system from exploitation. To benefit off the capital losses acquired, you might want to stick around and understand the nitty-gritties of this regulation. Triggering a wash-sale isn’t half as bad as not knowing how to navigate through it and ending up at your wit’s end. 

What is the Wash-Sale Rule? 📚

The wash-sale rule is an IRS regulation that invalidates a taxpayer’s claim to tax deduction benefits for a security traded in a wash-sale. A wash-sale occurs when an investor sells an asset at a loss only to repurchase a substantially identical security 30 days before or after the sale.

The rule is also applicable if the investor acquires an option or contract for a substantially identical asset. A wash-sale also applies to sales made from one account and the repurchase from a spousal account or a company’s account owned by the same individual.

In all such cases, the loss does not qualify for taxation and adds to the cost of the repurchase. This automatically balances your portfolio. The rule applies to stocks, security, options, mutual funds, and ETFs. 

Essentially, when an investor sells a stock only to redeem it, they “wash out” the tax benefits associated with the loss. This prevents them from exploiting tax benefits. Thus, no capital loss may be deducted on the trade without exiting the investment.

Understanding the Wash-Sale Rule In-Depth

We could regard the wash-sale rule as the backbone of maintaining discipline in the taxing system. After all, it exists essentially to prevent taxpayers from redeeming unwarranted losses under any investment strategy. 

The rule aims to target manipulation from taxpayers in selling and repurchasing stock. It prevents benefitting from a deductible loss in the account while being in possession of the original stock. Instead, it adjusts the loss to the repurchase price for accountability in taxation.

On paper, the strategy is a great move for handling a market downturn. However, respecting the wash-sale rule even helps create a more balanced portfolio. Simply, allow the wash-sale window to be over and go on investing in whatever stocks you like. 

Tax Loss Harvesting vs. Wash Sales ⚔

It is common for investments to devalue unexpectedly or show the possibility for a loss in the future. Such investments are usually sold-off to reinvest money in more prospective offers.

Thus, trying to profit from poorly performing securities is not a crime. In fact, there are ways you can manipulate this situation to mitigate losses, especially at the end of a tax year. In simple words, you can make profit from your losses simply by choosing the right time of trade. 

This process, called tax-loss harvesting, is about picking the right time to get rid of low-performing securities at a loss. If implemented, the capital loss appearing on the portfolio lowers the taxes applicable to the capital gains. If you have securities unlikely to yield any profitable results or you would like to relocate assets across different sectors, harvest your tax losses wisely.

In the long run, tax-loss harvesting can help categorize the portfolio into a lower-income bracket and reduce tax rates. However, trying to manipulate too much of the system can backfire at you. Some investors sell an unprofitable security at a loss with the intention to buy it back when it performs better.

With a cost basis lower than the original price, investors try to yield more taxable losses. The IRS controls the wash-sale rule to prevent this harm to federal tax revenue. If such a repurchase takes place within 30 days before or after the original trade, the tax losses are not allowed.

Example: How Wash-Sale Dates Are Counted 📝

Wash-sales are applicable on investments traded 30 days before or after the first sale. It does not matter how long the trader held onto the initial security. If a repurchase takes place within 30 days, the account has incurred a wash-sale.

The loss is moved forward and gets attached to the cost basis associated with repurchasing the security. If the repurchase also closes at a loss and the deal continues within 30-days, the loss gets carried to every new cost basis. 

Let’s say Michael purchases 100 shares of Amazon on Oct 25th. Each share costs $3, giving him a cost basis of $300 in the stock. The investment drops to a value of $1.5 by Oct 31st, and he sells back the 100 shares for $150. The trade has left him with a capital loss of $150. 

As per the rule, Michael cannot repurchase the same stock anytime between Oct 31st and Nov 29th. If he does so, a wash-sale will be triggered. Consequently, his cost basis will adjust according to its penalty.

Remember that the ruling would be the same even if the buy-and-sell takes place 30 days before the sale.

What Does it Mean for a Security to Be “Substantially Identical”? 🤔 

The application of a wash-sale rule is contingent on the interpretation of the term substantially identical. It is left upon the investor’s judgment and eventually the IRS to determine whether or not a particular case complies with it.

The Hanlin vs. Commissioner case of 1932 allowed the appellate court to introduce a relatively better interpretation of the idea. The case required the court to determine whether the concerned parties’ trading of bonds qualified for a wash-sale. 

Contrary to popular belief, the court dismissed the idea that substantially identical securities need to be indistinguishable. Instead, they declared that any similarities close to even precise correspondence would qualify for a wash-sale.

The case also set forth the criteria for determining this correspondence. Two securities count as substantially identical if there exists a similarity in any of their material features. Material features may include anything from time to maturity of the bond as long as it directly influences the bond’s value.

What Securities Are Not Considered “Substantially Identical”? 🗃

1. ☑ Different Companies:
Stocks of two different companies are not identical, even if they operate within the same industry. For example, if you incur a loss in Microsoft, you can invest in equal shares of Apple stocks. This alternative investment in the technology sector will likely profit you the same as Microsoft.

However, if two independent companies merge and consolidate their market share, their stocks will become substantially identical. Back in 2005, Google acquired Android OS for $50 million. Let us assume Michael had stocks in Android at a loss before the merge. He sold his shares in Android and invested in Google to remain relevant in the sector.

After the merge, the price of Android stock becomes directly proportional to Google. If the merge happens within 30-days after Michael’s trade, the IRS interprets his purchase as a wash sale.

2. ☑ Exchange-Traded Funds:
Two exchange-traded funds (ETFs) linked to the same index can potentially be very similar in composition. Thus, one could assume them as “substantially identical”. However, the differences in their regulations, expense ratio, and tax load present a well-grounded argument to consider them nonidentical.

For example, the Vanguard expense ratio stands at 0.04% compared to iShares’ 0.19%. So, if an investor sells Vanguard S&P 500 ETF at a loss but immediately harvests the loss by purchasing the iShares Core S&P 500 ETF, they shouldn’t be subject to a wash-sale.

3. ☑ Common and Preferred Stock:
Common and preferred stock are the two kinds of stock traded by companies with investors in the market. Both the stocks grant holders partial ownership of the company, albeit with some differences in their control structure.

Common stock is the more volatile form, granting voting rights and capital appreciation. With preferred stock, you acquire scheduled dividends, giving you more claim over the company’s stock but no voting rights.

Due to differences in voting rights for shareholders, the two stocks are not substantially identical. Thus, If a loss occurs in a company’s common stock, a repurchase is allowed in the same company’s preferred stock within the 30-day window.

Which Investments Does the Wash-Sale Rule Apply To? 📜

The U.S. Securities and Exchange Commission details the specifications that can make an investor liable to face a wash-sale. Essentially, it includes purchasing shares in the same or “substantially identical” stocks. The government does not set out a straightforward ruling for what substantially identical stocks can entail. This falls upon the investor’s best possible judgment.

A wash-sale can also be triggered if you are trading options contracts. This can include a call on the stock up for selling. The ruling applies to all accounts under the investor’s control. This includes an Individual Retirement Account (IRA), Roth IRA, a spousal account, or an account registered under any corporation owned.

Short Sales and Unequal Shares ⏳

A short sale refers to selling stock borrowed from a broker in hopes of buying it back at a profit when the price declines. If you come into a short-selling position at a loss, you cannot sell the same stock at a short position again within 30-days. Otherwise, a wash-sale is triggered.

In some situations, the number of shares sold is not equal to the ones bought in the first place. In that case, the rule divides the losses proportionally into all the unequal shares. Here’s how it works. Put all the purchases in chronological order. Start with the first purchase and compare it to all other purchases within 30-days.

Let’s say Michael sold 200 shares at a loss of $250. He then bought back 80 shares after 11 days and 120 shares after 14 days. The loss is split proportionally, with 40% going to the first purchase and 60% to the second.

The process repeats until every individual purchase compares itself with trades made 30-days before and after. What if the repurchase consists of only part of the shares? If Michael had bought 100 shares back of the 200 sold, only part of the $250 loss would have been carried forward. 

Divide the number of shares repurchased by the total number and multiply by the loss value. In this case, only $125 of the loss would adjust to the cost basis of the new purchase. 

What Happens if I Violate the Wash-Sale Rule? ⚠

If an investor violates the wash-sale rule, they are immediately subject to its consequences. The capital loss realized from selling the shares ceases to exist. Furthermore, the cost basis for the repurchased stock adjusts to include the loss value. 

Let us assume Michael repurchased the shares sold at $150 at a cost basis of $100 on Nov 15th. As per the wash-sale rule, his initial capital loss is no longer allowed. It will be declared null by adjusting the current cost basis. Due to the addition of the capital loss from Oct 31st, the cost for his purchase on Nov 15th is now $250.

If Michael goes on to resell the shares purchased on Nov 15th at a loss, he must be very careful about getting them back. Buying and selling the same stocks less than 30 days after the other will activate a chain of wash-sale adjustments. The greater the losses sustained in the trade, the higher the adjustments tend to rise.

What is the Ruling for IRA Sales? 👩‍⚖️

The IRS Publication specifies the wash-sale rule’s application to IRA accounts. However, for the longest time, it failed to highlight the ramifications of the situation.

Fortunately, later on, it presented the Revenue Ruling 2008-5 to detail the consequences of a wash-sale in an IRA trade account. Under section 1091 of the code, all losses incurred in an IRA account are disallowed and deferred from the cost basis. 

Let us assume that the transactions made during Oct-Nov were from an IRA account. Then, Michael’s purchase from Nov 15th would only cost $100, with the $150 loss from Oct 31st completely disallowed.

How Can I Avoid the Wash-Sale Rule? 🧐

Wash-sales may seem hard to navigate through, but it is not entirely impossible. All that is required is farsighted decision-making.

Let the 61-day Window Run its Course 🗓

Given the lack of clarity surrounding the scope of the wash-sale rule, the obvious move is the best one. Let the wash-sale window run its course for 30-days and invest wherever deemed fit on the 31st day. 

Avoid any same or substantially identical asset for this period. However, if it bothers you to have idle money sitting, look for a different stock in the same industry. For instance, try investing in Dell instead of HP.

Invest in Multiple Shares of the Same Stock 📂

Specific share identification is a common strategy employed by investors to manipulate capital losses and gains. With some quick thinking, it can help avoid a wash-sale. 

Let’s say Sara holds multiple shares in the same stock, each purchased against a different price value at a different time of the year. 

Instead of selling a specific share, trade the ones with the highest cost basis. This will automatically minimize the capital gain, making the account eligible for reduced tax liability during the year of trade. 

For example, she purchased a 100 on Facebook for $200, but it is now down to $20. Instead of selling the stocks back for a loss, she will purchase new shares in the same stock at the new price. Then, after the 30-day window is over, sell the $200 shares to maximize the capital losses to report. 

However, the method requires advanced planning. There needs to be proper maintenance of the cost basis for all funds. Keep in mind that only part of the shares are up for sale at a time. 

If the trade consists of a high-cost share held only for a year or less, the short-term capital gain will fall prey to income-tax rates.

Find a Substantially Non-Identical Investment 🎯

Investment goals and tax liabilities can float in the same boat. How? Simply through navigating the thin boundaries of the wash-sale rule cleverly.

For instance, if James liquidates a holding in Dell, he can buy shares in HP after deduction of loss. Purchasing funds in the same sector could also work for portfolio allocation. Thus, remaining relevant in the sector gives a prospective margin of acquiring comparable results. 

Having said that, switching industries completely removes the possibility of a wash-sale. Get a financial advisor on board to best judge the alternative investment that suits the situation’s tax-loss harvesting requirement.

Have an Investment Plan 💭

A wash-sale can be a clear hint of the need for disciplined investment planning. Short-term downturns or unrealistic turns are common in the market. Without a long-term strategy, investors can end up panic purchasing/selling at the spur of the moment. 

Tackling wash-sales can appear easy in text but much harder when dealing with a large number of purchases, including short sales and unequal shares. Having someone else to take the burden and devise a comprehensive plan can make it easy to bypass the rule. It also systemises cross-checking and ensures timely report submission to the IRS. 

Either reach out to a trusted financial advisor or take the computer-aided route. Choose the most suitable robo-advisor, and let them preplan all financial moves.

How are Wash Sales Reported? 👨‍💻

The IRIS expects all investors and financial institutions to report the investment sales through individual accounts. For this purpose, Form 8949 is available on the IRS’ website, along with complete instructions for filling it out. This report communicates all capital gains and losses, including the wash-sales.

Form 1099-B is also to be filled by the brokers to report wash-sales to the IRS. A copy of it is also provided to the investor to utilize in filling out form 8949.

Calculating Wash-Sales 🧮

The form 1099-B issued by the broker is likely an inadequate summary of all the wash-sales. The brokers are only required to track and monitor transactions with the same CUSIP number.

However, an investor must report wash-sales across all the accounts owned, including IRA, company, and spousal accounts. Thus, an investor must track wash-sales in all accounts under his name or ownership.

To calculate each wash-sale, scan through the transactions and highlight the trades generating a loss. Check 30-days before and after each trade to locate the purchase of a substantially identical asset. If there is any identical purchase in the 30-day window, adjust its cost by adding the loss. Lastly, report the wash-sale adjustment line on schedule D.

The process remains the same for every trade made during the year. Remember that the adjustment rules will vary for unequal shares and short sales.  This is the cue to understand that the task is harder than it seems. Or, as penned by Forbes, “a tax return headache”.

When to Manage Wash-Sales Critically? 🕵️‍♂️

Since the losses deferred in a wash-sale come full circle after the cycle is over, they can present a hit-and-miss situation. For the most part, the penalty is damaging for the portfolio, but there are two situations an active trader can use to their advantage.

First, check if there are any positions held open in December. If there are wash-sales in the portfolio at the year-end, they will shift to the next tax year. 

Carrying losses from subsequent wash-sale purchases allows an investor to manipulate them. Once they shift to the next tax year, they will offset profit and other gains to reduce the tax returns.

Second, if a portfolio already shows a low-income threshold, a wash-sale could drive it further into a low-income bracket. This is especially useful when you already have deductible losses in your account. Now, all your capital gains will be subject to the long-term 0% tax rate for the ongoing tax year.  

Conclusion 🏁

Ultimately, any creative workarounds in bypassing the system put you at risk of the system’s mercy itself. The wash-sale rule, as unpleasant as it may be, is a reality we must accept. 

If triggered, the wash-sale rule may take away a valuable loss deduction and inflict long-term damage to the portfolio. It is easy to forget while you are going in and out of shares one after the other. Rather than risking it all by activating one, it is better to devise safer tax-harvesting strategies. 

Acquaint yourself with substantially identical securities, the workarounds of the rule and always keep a lookout for the 60-day window. Harvesting losses can be very advantageous—but let us make sure we comply with the law while doing so.

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