A wash sale transaction is when taxpayers try to “wash” capital losses on trading transactions.
As a taxpayer, you cannot sell a stock at a loss and immediately repurchase the same or identical securities within 30 days.
Let us discuss what is the wash sale rule, how it works, and how you can avoid it.
What is the Wash Sale Rule?
The wash sale rule is set by the Internal Revenue Service (IRS) to prevent taxpayers from selling and repurchasing the same or substantially identical security within 30 days.
The IRS defines the wash rule under these four points or conditions when you:
1. Buy substantially identical stock or securities,
2. Acquire substantially identical stock or securities in a fully taxable trade,
3. Acquire a contract or option to buy substantially identical stock or securities, or
4. Acquire substantially identical stock for your individual retirement arrangement (IRA) or Roth IRA.
In practice, the wash sale rule applies to trading securities through a wash sale 30 days before or 30 days after the loss-making transaction. So, the total span of the wash sale rule is 61 days for compliance purposes.
The wash sale rule applies if your spouse or partner performs the transaction. Even if you file taxes separately, the rule would apply.
Similarly, if you perform the wash sale transaction through a corporation owned, you’ll be penalized by the IRS.
How Does the Wash Sale Rule Apply?
The “wash sale” is made up of two transactions. The first is when you sell a stock or financial security at a loss on a specific day.
The second transaction is to buy the same stock or financial security within 30 days of selling it. If you purchase substantially identical security, the rule would apply.
In some cases, the investor would sell and repurchase the stocks in different numbers. In that case, the wash sale rule would apply to the number of stocks sold and repurchased. Excessive stocks repurchased would be treated normally.
There are no clear instructions from the IRS to define substantially Identical securities. The IRS states that determining the wash sale under this definition depends on the investor’s circumstances and will be determined after assessing the transaction.
Generally speaking, if an investor sells a stock and repurchases a derivative contract like Options, Futures, and Forwards, it will be considered identical security.
Similarly, reinvesting in stock through ETFs will be the same. However, if you invest in a mutual fund that also holds your recently sold stock, it cannot be considered a wash sale transaction.
Reinvesting in cryptocurrencies after selling a loss-making one does not fall under the wash sale rule. It is because the IRS does not define cryptocurrencies as stock market assets. It defines them as “property”.
Suppose you purchased 1,000 shares of ABC Company on May 15 20xx. The share price at that time was $10 per share.
On October 10 20xx, you realize that the stock has fallen to $8 and you want to sell them. So, you sell all these 1,000 stocks at a capital loss of $2,000.
Now, suppose you reconsider purchasing the same ABC stock again considering it will rise again.
If you make a transaction before November 10 20xx, it will be considered a wash sale. If you do so, your capital loss of $2,000 will be disallowed for the tax year 20xx.
However, if you repurchase the ABC stock on or after November 10 20xx, you can use the $2,000 capital loss for tax savings.
The wash sale rule would still hold if you had purchased ABC stocks 30 days before selling these stocks. In this case, on or after September 11 20xx.
Deferring the Tax Loss
We can understand deferring the tax losses under the wash sale rule by continuing our example above.
Suppose you broke the wash sale rule and purchased an identical security before 30 days. Thus, your $2,000 capital tax loss is disallowed.
Now, when you purchased the identical security worth $ 10,000 again, the previous tax loss of $2,000 is added to this transaction at the purchase cost.
So, your total cost of repurchasing the stocks (or identical security) becomes $ 12,000 instead of $ 10,000.
This way, your deferred tax losses through wash sale transactions would be carried forward to your next transactions until settled. It means, your tax losses cannot be eliminated and must be settled with the IRS.
How to Avoid the Wash Sale Penalty?
The simplest way to avoid a wash sale penalty is to follow the rule and wait for 30 days before you make another purchase. However, that’s the dilemma you face in this situation.
The first strategy is to purchase the same stocks at a new price first. Then, you hold the old batch of those stocks for at least 30 days to avoid the wash sale rule.
Once your probation period of the rule expires, you can now sell the old stock batch at the current market price.
This way, you have avoided the wash sale rule and you can fully utilize the capital loss for tax savings.
The drawback of this strategy is the substantial cost of purchasing double stocks. The cheaper strategy is to invest in a call option.
You can purchase the same number of stocks through a call option at a much lower cost than purchasing the stocks outright.
However, you’ll still need to follow the wash sale rule and must hold the stocks for at least 30 days to avoid the penalty.
Repurchasing the sold stocks through your IRA or Roth IRA will also trigger the wash sale rule. The IRS defines the same rule for a transaction made through IRAs as well.
Reporting the Wash Sale Transaction
If you incur a wash sale to make substantial gains, you’ll need to report this transaction to the IRS.
Your stock investments are reported to the IRS on Form 8949 on Schedule D. you’ll need to identify the wash sale transactions on column “f” of the form by writing “w”.
You should identify all wash sale transactions on Form 8949 the same way to report proper tax returns.
When to use the Wash Sale for Your Benefit?
Some investors may intentionally break the wash sale rule to carry forward the tax losses into the next tax year. They may do so if they are in a high tax bracket this year and harvesting the capital tax losses might push you back into a lower tax bracket.
Deferring the tax losses to the next tax year is the prime reason why taxpayers break the wash sale rule.
Another reason can be to regain the investment profits if you made a wrong move. If you sold the stocks and they started moving upwards again, you may want to repurchase the stocks quickly.
However, both these strategies require planning and careful execution as the cost of negligence can be very high.
FAQs on the Wash Sale Rule
Here are a few frequently asked questions (FAQs) on the wash sale rule.
Does the Wash Sale Rule Apply to Capital Gains too?
No, the wash sale rule applies to transactions with capital losses only. It does not apply when you make capital gains and repurchase the same or identical securities.
How Does the IRS define Identical Securities?
There are no clear instructions from the IRS. It states that the definition of identical securities would be set under the circumstances of each transaction and the taxpayer must make a reasonable attempt to determine it.
What if Your Spouse or Partner Purchases an Identical Security?
The wash sale rule holds even if your spouse or partner purchases identical security or the same stocks within 30 days.
The same holds when you make the transaction through a corporation owned by you.
How to Carry Forward the Losses?
You can report the wash sale transactions on Form 8949 and carry forward the tax losses to the next tax year if you see a benefit.
How to Report a Wash Sale Transaction?
You’ll report the wash sale transactions on Form 8949 on Schedule D. in column “f”, you must identify the wash sale with the word “w”.