The tax code generally allows investors who sell an investment at a loss to deduct that loss in determining their taxable income. But to prevent investors from abusing that tax break by selling securities held at a loss solely to recognize a tax benefit, the tax code has, for many years, included a “wash sale” rule, which disallows the deduction if the investor acquires a “substantially identical” security any time from 30 days before the sale to 30 days after the sale.1
What is a wash sale?
A wash sale is a sale of an investment for a loss coupled with a purchase of the same investment or one that’s “substantially identical” within the period from 30 days before the sale date to 30 days after the sale date.
Generally, a gain from selling an asset for more than you bought it is subject to capital gains tax. And if you sell an asset for less than you bought it, you can use that loss to offset capital gains realized in the same year. If your capital losses exceed your capital gains, you can deduct up to $3,000 of the loss from your other taxable income and carry forward any excess indefinitely.2 (Technically, gain or loss is measured from your “cost basis,” which is often – but not always – until you sell the replacement securities.
One common example is with a publicly traded company’s common stock. If you own 100 shares of ABC Manufacturing at a cost basis of $100 per share and the price falls to $50 per share on January 2, you might feel like selling that day to unload a losing stock and realize a $5,000 loss. If you do that, you can use the $5,000 loss to reduce any capital gains you have that year, and if you have less than $5,000 in gains you can use up to $3,000 of the excess loss to write off against other income.
But what if ABC’s stock falls to $35 per share by January 29? You believe that the stock is a bargain at that price and you want to buy your 100 shares back. This is a “wash” because the purchase was made only 27 days after your sale. As a result, you can’t use your loss of $5,000. Instead, the disallowed loss is added to your basis, so you now hold 100 shares of ABC with a basis of $85/share (the $35 that you paid when you repurchased the shares plus the $50/share loss that you realized on January 2).
What happens next?
- If the stock price didn’t go up at all and you decided to sell it at $35 (and not repurchase it), you would have a $50 loss – the loss that was originally disallowed when you had the wash sale by repurchasing the stock. You didn’t “lose the loss,” you just weren’t able to use it until later. If the final sale took place in the same year as the repurchase, you could use the loss that year after all. But if that final sale takes place in a later year, that’s when you can use the loss to reduce your taxes.
- On the other hand, let’s say that ABC goes back up to $100 and you decide to sell it. (Even though that is what you originally bought it for, note that you have realized a net $15 trading profit from selling the stock at $50 and buying it back at $35). In that case, you would have a $15 taxable gain – the $100 sale price minus your $85 basis (the $35 you paid plus the $50 that was deferred).
- That’s the same as if you bought stock at $100, sold it at a $50 loss, then bought the stock at $35 and sold it for $100. In that case, you’d have a $65 gain but you’d be able to use the $50 loss (assuming all this took place in the same year), so your net gain would be $15 – exactly where you ended up.
Note that the wash sale period extends from 30 days before the sale to 30 days after the sale – and neither of those 30-day periods includes the sale date, so you can’t buy that “substantially identical” security within a 61-day window.
- For example, let’s say you sell ABC stock on July 15. 30 days prior to that is June 15; 30 days after is August 14. In order to avoid a wash sale you would have to have bought ABC stock before July 15 or after August 14. The wash sale period includes the date of sale plus or minus 30 days.
The rules are more complex if you buy back fewer shares than you sell; if you have a complicated wash sale situation you should consult with a tax professional.
The “wash sale rule” is what we’ve been discussing – it’s the rule that prevents you from claiming an immediate tax loss on assets you sell if you purchase a substantially similar asset within that 61-day wash sale period.
What is “tax-loss harvesting” and how does it relate to the wash sale rule?
Tax-loss harvesting is the deliberate selling of positions held at a loss to take advantage of the tax benefits of realizing losses. Most people think about tax-loss harvesting toward the end of the year, but it’s good to think about it throughout the year, since even in a rising market you may have a few individual positions that have experienced a loss from the time you purchased them.
When you’re considering tax-loss harvesting, you should always keep the wash sale rule in mind. This is especially true if you have multiple accounts and if you rely on professional money managers to manage a separate account for you. If you sell a stock in one account for a loss and your manager buys that stock within the wash sale period, it’s a wash sale even if you didn’t direct the specific purchase. (This is only true for separate accounts, including IRAs, but not for transactions inside a mutual fund or ETF you own.)
For a more detailed description of tax-loss harvesting and how you might benefit from it, please see our Wealth Focus article “Why you may benefit from tax-loss harvesting.”
How to avoid violating the wash sale rule
There aren’t many easy answers when it comes to making investment decisions, but in the case of the wash sale rule there is one easy answer: Be aware of the 61-day window around a sale of your investments. If you sold a loss position on Day 1 and felt you had made a mistake by Day 15, if you wait until Day 32 (not 31!) to buy back your position, you can still deduct the loss and own the security. If you want to buy it back sooner, you can – but you can’t claim the loss on your taxes if you do.
What does it mean for a security to be “substantially identical?”
The wash sale rule says you can’t buy a security that is “substantially identical” to the one you sold within the 61-day window. But what does “substantially identical” mean?
The easy example is a company’s stock. You sold ABC common stock and then you bought it back. Wash sale. Case closed.
But what if you buy preferred stock of the same company? Or options to purchase the company’s stock? What about selling an ETF or index fund tracking the S&P 500 and then buying a different exchange-traded fund (ETF) or index fund from a different company but also tracking the S&P 500? What about selling one bond issued by a company and buying a different bond issued by the same company?
Some of the answers are clear:
- Buying the same stock in a different account is still a wash sale. Even your IRA. So if you sell stock in your brokerage account and buy the same stock in your IRA, it’s a wash sale. It may not be reported by your broker as a wash sale, but that loss is disallowed. And the problem with doing that is that assets in your IRA don’t have a basis, so you won’t have the opportunity to use the deferred loss when you eventually sell the stock.
- Buying a call option (which gives you the right to buy shares) is a wash sale. Period. It doesn’t matter if the option is in the money or not.
- Selling one stock in a sector and buying the stock of a different company in the same sector is NOT a wash sale as long as the companies aren’t otherwise linked.
- For example, if Company A is going to buy Company B and you own Company B stock at a loss, you can’t sell Company B stock, immediately buy Company A stock, and realize the loss in the sale of your Company B stock.
- But if you sell one snack-food and soda stock and buy a different one, or sell stock in one computer manufacturer and buy stock in a different one, it’s not a wash sale.
- Selling a stock and buying an ETF or mutual fund that covers that stock’s sector – even if the stock is owned by the fund – is not a wash sale (it also has the benefit of diversifying your overall exposure to individual stocks).
Other circ*mstances are less clear:
- Selling a put option may be a wash sale, but generally only if the option is deeply “in the money.”
- Selling common stock and buying preferred stock or bonds of the same company is generally not a wash sale – but if the preferred stock or bond is convertible into common stock it may be.
- Selling one bond and buying another, even from the same issuer, may not be a wash sale – depending on the coupon, maturity, credit rating, and other factors. The more different the two bonds are, the less likely it will be deemed a wash sale.
- Selling a mutual fund or ETF and buying a similar one may or may not be a wash sale depending, among other things, on how similar the funds or ETFs trade.
- If you can overlay the price chart of one fund on the price chart of the replacement and see no difference, it’s more likely going to be deemed to be a wash sale, since the wash sale rule tries to prevent you from using a loss if you haven’t changed your market exposure.
Ultimately, you must consider all the facts and circ*mstances in your particular case when determining whether stock or securities are substantially identical – and working with a qualified tax professional is a good way to ensure that you don’t inadvertently run afoul of the rule.3
If you are in doubt, contact a tax professional for guidance.
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