What Is An Example of a Wash Sale?

What is an Example of a Wash Sale?

Posted by Sebastian Abrigo on Nov 5, 2022

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Day traders can violate the wash sale rule because of their trading frequency. However, it isn’t only day traders who are susceptible to this tax rule. The worst part is that many people have no idea how it works or that it exists, allowing the rule to creep up on them. The result can be an increased tax bill. We’re going to look at what the wash sale rule is, along with a few examples of how it works.

What Is The Wash Sale Rule?

When you sell a security for a loss and buy the same or substantially similar security within 30 days before or after the sale, the loss is disallowed. This creates a 61-day window that the wash sale rule is in effect — 30 days before the sale + day of sale + 30 days after the sale.

What qualifies as a similar or related security? This is the taxpayer’s responsibility. Brokers must only report wash sales for individual accounts and investments with the same CUSIP (financial instrument identifier).

Investors with multiple accounts who create a wash sale across any of those accounts must keep track of wash sales. This also applies to retirement accounts, such as IRAs. The situation in an IRA is much worse than in a taxable account. The cost basis is not adjusted if a wash sale occurs in an IRA. Instead, the loss is permanently disallowed.

How Does The Wash Sale Rule Work?

The best way to understand how the wash sale rule works is with examples.

Example 1:

Buy a stock for $100. Sometime later, sell it at $75, resulting in a $25 loss. One week later, rebuy it for $80. Because the same stock was purchased one week later, it is within the wash sale window. Rather than an $80 cost basis, the loss is added to the cost basis, making the new cost basis $105.

The loss isn’t gone indefinitely. It can be reclaimed later if the trade is closed outside the wash sale window for a loss. In the above example, it would have to be closed below $105 instead of $80.

How do the 30 days before and after a sale for a loss apply? Let’s say you sell 100 shares of ABC on Sep 15. This creates a 61-day window that runs from Aug 16 thru Oct 15. During this window, you can’t purchase ABC. Otherwise, the wash sale rule will be triggered.

Example 2:

An investor bought ABC on Monday for $100. On Tuesday, the stock dropped to $90, and the investor sold, generating a $10 loss. The investor then buys ABC for $92 on Wednesday, creating a wash sell. Additionally, the new cost basis becomes $102.

To see an extreme case of the wash sale rule in action, Morningstar wrote about an individual in Arizona who owed $800,000 in taxes on only $45k in profits. If you are wondering how that is even possible, the wash sale rule is mostly responsible. Here’s how it played out.

The individual made $60k a year at his day job as an insurance agent. In 2020, he opened a brokerage account with $30,000. The broker gave the trader 3X leverage, allowing $90,000 for day trading. The trader went on to trade between 10-50 trades per day. This is a significant amount of trading, generating $45 million in trade volume for only $45,000 in gains that year.

After the trader completed his tax return, he had $1.4 million in gains, creating an $800,000 tax bill. You can imagine that his Form 1099-B was probably many pages long.

The trader’s big mistake was not understanding how the wash sale rule works. He didn’t wait the necessary amount of time to trade the same or similar stock after taking a loss. Thus, the losses were disallowed, leaving only gains. These gains were short-term gains as well because of day trading, which means they are taxed at the trader’s ordinary income tax rate.

Note that the wash sale applies to both stocks and options. However, it doesn’t apply to futures.

Before closing a trade for a loss, keep the wash sale rule in mind. In many cases, it may not apply. But now that you know it exists, you may be able to save yourself some future headaches.

 

This material is for general information and educational purposes only. Information is based on data gathered from what we believe are reliable sources. It is not guaranteed as to accuracy, does not purport to be complete and is not intended to be used as a primary basis for investment decisions. It should also not be construed as advice meeting the particular investment needs of any investor.

Realized does not provide tax or legal advice. This material is not a substitute for seeking the advice of a qualified professional for your individual situation.

Hypothetical examples shown are for illustrative purposes only.

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