Gains and losses are part of investment activity. While the IRS taxes your capital gains, you could use the capital losses to offset taxable income, provided you're not triggering the wash sale rule. Unfortunately, many investors unwittingly trigger the wash sale rule when they reinvest dividends or rebalance portfolios after selling at a loss.
You should understand the wash sale rule and its ramifications on your investment activities. Failure to do so could result in unexpected tax liabilities.
What Is a Wash Sale?
A wash sale occurs when an investor sells or trades a security at a loss and then repurchases the same or a similar security within 30 days before or after the sale. Wash sales apply to a wide range of investments, such as stocks, mutual funds, ETFs, options, and automatically reinvested dividends.
The IRS doesn’t care if you make a wash sale. However, the IRS doesn’t want you to use that loss to offset your income and decrease your liability.
If a transaction is classified as a wash sale, the realized loss is disallowed for tax purposes and is instead added to the cost basis of the repurchased security.
The purpose of this rule is to prevent taxpayers from generating artificial or short-term losses for the sole purpose of reducing taxable income, while effectively maintaining their investment position.
Here’s an example
- Investor James buys 100 shares of Y stock at $50 per share.
- When the Y stock price falls, James sells for $40 per share, resulting in a $1,000 loss.
- A week later, James rebuys Y stock at $42 per share.
- The wash sale rule prevents James from deducting the $1,000 loss from his income as a capital loss. Instead, the loss is added to the repurchased shares’ cost basis. James’s new cost basis becomes $5,200 ($4,200 purchase price + $1,000 deferred loss), which will adjust the calculation of gain or loss when these shares are eventually sold in a non-wash-sale transaction.
There’s also the matter of holding periods. When a wash sale occurs, the holding period of the sold shares is added to the holding period of just-acquired shares, determining whether the gain or loss is short- or long-term. The difference can impact tax liabilities.
Consequences of Violating the Wash Sale Rule
There are no direct fines or penalties if you violate the wash sale rule. However, the practice could result in unexpected tax consequences. You forfeit the right to use capital losses as part of a tax-harvesting strategy. You could face higher taxable income than what was initially anticipated.
As mentioned above, the disallowed loss is added to the cost basis of the replacement security. This adjustment defers the recognition of the loss rather than eliminating it. But it also means you can’t use that loss to offset current-year gains.
Strategies to Avoid Wash Sale Violations
By itself, a wash sale isn’t wrong. Rules only apply when you use the losses from the wash sale to offset your taxable income. Here are approaches to follow that can help you avoid violating the rule.
Buy Before or After 31 Days
One way to prevent a transaction from being classified as a wash sale is to make a transaction after the 30-day timeframe is over. However, this practice could mean missing potential gains or incurring further losses if the security’s price fluctuates.
Acquire Similar–Not Identical–Securities
With some research, you can find securities offering similar market exposure without being too identical to the securities you just sold. For example, instead of repurchasing shares of a specific large-cap tech stock, you could invest in a broad-based technology sector ETF. However, substitute securities may not perform in line with the original investment, and differences in volatility, composition, or costs could affect outcomes. Additionally, depending on the overlap in holdings or structure, some substitute investments may still be subject to IRS scrutiny under the wash sale rule.
Turn Off Automatic Reinvestments
Automatic dividend reinvestment plans (DRIPs) can result in the purchase of substantially identical securities within the 30-day window surrounding a loss-generating sale, potentially triggering the wash sale rule. However, disabling DRIPs to avoid this outcome may also interrupt long-term compounding strategies or alter an investor’s planned reinvestment schedule.
Common Wash Sale Pitfalls
While the wash sale rule’s provisions may seem easy enough to follow, things can get tricky in real life, especially if you’re a frequent trader or rely on automated reinvestment strategies.
For example, you could unknowingly trigger a wash sale by purchasing the same security with a different account. This activity could mean long-term tax consequences, including higher tax liabilities from IRA distributions.
Additionally, tracking wash sales across multiple transactions could be problematic. You could accumulate disallowed losses if you are a frequent trader who sells and rebuys the same stock within short periods. This could complicate cost basis calculations and tax reporting, with inaccuracies leading to penalties down the line.
Finally, the IRS doesn’t clearly define “substantially identical” securities. Such vagueness could mean you might trade securities you assumed were dissimilar, only to have the IRS tell you that those assets are “substantially identical” and that you violate the wash sale rule.
Protecting Your Investments: Knowing the Wash Sale Rule
The wash sale rule is in place to prevent investors from buying and selling substantially identical securities only for the purpose of generating artificial tax losses. However, you could unwittingly trigger the regulation in various ways. Be sure to work with your tax expert or other professional for guidance in navigating this tricky rule.
Examples are used for illustrative purposes only.
The tax and estate planning information offered by the advisor is general in nature. It is provided for informational purposes only and should not be construed as legal or tax advice. Always consult an attorney or tax professional regarding your specific legal or tax situation.
