Anyone who has ever invested his or her money in the stock market usually comes across the term wash sale. Typically no one thinks of wash sales until they hear that little voice in the back of their head in the spring saying, “Hey be careful what investment losses you try and write-off or the mean IRS will come knocking.” Maybe you haven’t heard that voice, but if you are the average investor, and want to make sure you are following the laws of the land then you have come to right place.
First, we need to establish what the wash sale rule is. According to the IRS, a wash sale occurs when you sell or trade stock or securities at a loss, and within 30 days before or after the sale you:
A) Buy substantially identical stock or securities,
B) Acquire substantially identical stock or securities in a fully taxable trade,
C) Acquire a contract or option to buy substantially identical stock or securities, or
D) Acquire substantially identical stock for your individual retirement account (IRA) or Roth IRA.
Second, we must ascertain whether the replacement stock or securities are deemed substantially identical. The most often used example of purchasing substantially identical investments, would be buying the exact same stock. However, in some instances shares in Mutual Funds that are invested in a host of stocks or different Exchange Traded Funds or ETF’s that mimic the same security would count as substantially identical. If you are like me, then you probably need to see some real numbers at this point. Below I’ve given an example of a basic wash sale.
This example comes directly from our friends at the IRS:
You buy 100 shares of a stock for $1,000. You sell these shares for $750 giving you a loss of $250. Within 30 days of the sale you buy 100 shares of the same stock for $800. Because you bought substantially identical replacement stock, you cannot deduct your loss of $250 on the sale. However, you add the disallowed loss of $250 to the cost of the new stock purchased, $800, to obtain your basis in the replacement stock of $1,050.
In the IRS’s example, we notice they mention that while you cannot write off the loss you can add it to the basis of the replacement stock. This means that if you purchased the new stock for $800, when you add your loss of $250 from the wash sale to it you achieve a new stock basis of $1,050. There are two primary benefits of being allowed to add the wash sale to your replacement stock basis. One, you get to change the holding date of the replacement shares to reflect the holding period of the wash sale shares. This can be helpful if you hold the replacement shares long enough to qualify for the 15% long-term capital gains tax rate. Two, with the higher stock basis your taxable gains will be less and deductible losses will be greater for tax purposes when you sell the replacement securities.
If you get nothing else out of this article, please pay attention to the following sentence. Essentially the wash sale rule states that you cannot write off a loss on your tax return for stock or securities that you purchased replacement shares for either 30 days before or after the day of your losing sale.