What Is a Wash Sale?
Let me explain what a wash sale is directly: it's a transaction where you, as an investor, sell or trade a security at a loss and then purchase a substantially similar one within 30 days before or after that sale. This rule comes from the Internal Revenue Service (IRS) to stop you from exploiting capital losses to lower your taxes.
You need to know this applies to stocks, contracts, options, and all other types of securities and trading activities.
Understanding Wash Sales
In the U.S., tax laws let you claim up to $3,000 in capital losses or your total net loss—whichever is smaller—as a reduction on your income taxes. If your losses exceed that, you can carry them forward to future years.
Investors figured out a way around this by selling losing securities and quickly buying similar ones back, claiming the loss to cut taxes while keeping their position. To close this loophole, the IRS created the wash sale rule. In places like the U.K., it's called bed-and-breakfasting, with similar restrictions.
The rule is clear: if you buy a security within 30 days before or after selling it at a loss, you can't count that loss against your reported income. This removes any reason to try short-term wash sales.
How It Works
Here's how a wash sale typically unfolds in three parts. First, you spot a losing position and sell the stock or exit the trade to realize the loss. Second, that sale lets you claim the loss on your taxes, reducing your earnings and tax bill for the year. Third, if you buy the security back at or below the sale price within 30 days before or after, it's a wash sale, and you can't claim the loss.
Day traders, especially pattern day traders who make more than four day trades in five days on margin, often run into wash sales. The rule applies to you just the same, and tax matters for day trading are complicated—consult a tax professional if that's your approach.
Wash Sale Example
Consider this scenario: you have a $15,000 capital gain from selling ABC stock, and at the top tax bracket, you'd owe 20% or $3,000 in capital gains tax. But if you sold XYZ security for a $7,000 loss, your net gain becomes $8,000, so you pay only $1,600 in tax. That XYZ loss offsets the ABC gain and lowers your bill.
However, if you repurchase XYZ or something substantially identical within 30 days, it's a wash sale, and you can't use that $7,000 loss to offset gains.
Special Considerations
The IRS usually doesn't see bonds or preferred stock as substantially identical to a company's common stock. But watch out—if preferred stock converts to common without restrictions, has the same voting rights, and trades near the conversion ratio, it could count as identical.
Also, per Revenue Ruling 2008-5, this rule hits IRA transactions too. If you sell shares in a non-retirement account and buy identical ones in an IRA within 30 days, you can't claim the loss, and your IRA basis doesn't increase.
Reporting a Wash Sale Loss
Not all is lost with a wash sale—the realized loss gets added to the cost basis of the newly purchased identical security. This raises the basis, cutting future taxable gains when you sell later.
You still get credit for the loss, just deferred. Plus, the holding period from the wash sale adds to the new security's period, helping you qualify for the 15% long-term capital gains rate.
Be cautious with tax-loss harvesting, where you sell at a loss to offset gains and buy replacements to keep your portfolio balanced. If you're not careful, you trigger wash sales. Opt for similar but not identical investments to avoid this.
Common Questions
What triggers the wash sale rule? It's triggered if you buy a substantially similar security 30 days before or after selling one at a loss.
Is the wash sale window 30 or 60 days? It's a 60-day window overall, covering 30 days before and 30 days after the sale.
Is it okay to have wash sales? It's not illegal to buy back within that window, but you can't deduct the losses to offset taxable income.
The Bottom Line
To wrap this up, a wash sale is when you sell a security at a loss and buy the same or similar one within 30 days before or after. The IRS designed this to stop you from deducting those losses if you reenter the position too soon. It's not illegal, but it blocks using the loss to offset gains that year.
Instead, add the loss to the new security's cost basis for future benefits. This applies to all securities and is key for day traders or anyone managing taxes through losses. Understand this rule for solid tax planning and investing.
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