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Wash Sale: Meaning, How to Avoid it, Penalty

Reviewed by Erika RasureFact checked by Suzanne KvilhaugReviewed by Erika RasureFact checked by Suzanne Kvilhaug

A wash sale is a transaction in which an investor sells a losing security to claim a capital loss, and within 30 days before or after the sale, they:

  • Buy substantially the same securities,
  • Acquire substantially the same securities in a fully taxable trade or
  • Acquire an option to buy substantially the same securities.

Some investors attempt to use this wash sale technique to realize a tax loss without eliminating their exposure to the market in that security.

Key Takeways

  • A wash sale occurs when an investor sells a security at a loss and within 30 days before or after that sale purchases the same or substantially similar security.
  • The IRS has not explicitly defined a “substantially similar” security.
  • A disallowed loss is usually added to the cost basis of the repurchased security.
  • Generally, stock of another company or an option or bond in the same company is not a substantially similar security.
  • Some automated investment programs, like dividend reinvestments, can cause unintentional violations of the Wash Sale Rule.

Understanding Wash Sale

The Internal Revenue Service (IRS) established the Wash Sale Rule to discourage selling a security at a loss solely to take advantage of a tax deduction. The rule prohibits selling a security at a loss and repurchasing the same security, or one that is substantially identical, within 30 days before or after the sale or acquiring an option to do so. The rule doesn’t prohibit the sale itself; instead, it prohibits the investor from claiming the loss for tax purposes.

The IRS did not define “substantially similar” in the rule. Thus, investors seeking to avoid a wash sale must look at various guidance provided over the years in IRS rulings and letters. One of the more helpful tests is the facts and circumstances test, which states that to determine whether securities are substantially similar, the investor should consider all the facts and circumstances in that particular case.

According to the IRS, securities of one corporation are not substantially similar to securities of another corporation, nor are bonds or preferred stock or bonds of a corporation considered substantially similar to the common stock of that corporation.

Key Point

There are legitimate ways to avoid the impact of the Wash Sale Rule.

Example of a Wash Sale

For example, an investor buys 100 shares of XYZ technology stock on Nov. 1 for $10,000. On December 15, the value of the 100 shares has declined to $7,000. So the investor sells the entire position to realize a capital loss of $3,000 to claim a tax deduction. Then on Dec. 25 of the same year, the investor repurchases the 100 shares of XYZ tech stock to reestablish the position in the stock. According to the wash-sale rule, the loss would not be allowed, as the investor would have repurchased the security within the 30-day limit.

Can You Avoid the Wash-Sale Rule?

There are simple techniques that investors can use to stay in the market for a particular security until the wash-sale period has expired. For example, if the investor sold the 100 shares of XYZ tech stock on Dec. 15, the investor could have purchased a technology exchange-traded fund (ETF) or tech mutual fund to retain some holdings in the technology sector.

This strategy will not replicate the initial position precisely because of the different financial instruments involved. If desired, when the 30-day period passes, the investor can sell the mutual fund or ETF and once more repurchase XYZ stock. Of course, an investor can always repurchase the stocks before the expiration end of the 30-day period, but then the investor will not be able to realize a tax deduction from the initial loss.

Another simple technique for avoiding the effects of the rule is to purchase additional shares of the stock and hold those shares for 31 days. At that point, the investor can sell the shares producing the highest loss and can claim that loss for tax purposes.

It is important to note, however, that an investor cannot avoid the impact of the rule by buying in one account and selling in another. The rule is applied to each investor, not to each account. In other words, if an investor sells at a loss in one account and purchases the same or substantially similar security in another account within 30 days before or after the sale, the Wash Sale Rule will apply to that transaction. Broker-dealers only report wash sales within the same account; investors are responsible for reporting inter-account wash sales.

Similarly, an investor cannot avoid the impact of the rule by having one spouse sell while the other buys. The IRS considers the two spouses as a unit and will disallow the loss. The same rule applies to a business owned by the investor. The transactions of the business and the investor will count as sales by one unit. If an investor repurchases the securities in an IRA account, not only will the loss be disallowed, but also the loss will not be added to the cost basis of the shares.

It’s important to remember the effects of the Wash Sale Rule when engaging in the tax-loss harvesting at year-end. Any stocks sold by December 31 for tax-loss purposes cannot be repurchased until at least January 31 of the next year or the loss will be disallowed.

Finally, investors cannot avoid the rule by buying and then selling at a loss within 30 days. The order in which the buy and sell occur is irrelevant to the Wash Sale Rule. Any purchase of the same or substantially similar security within 30 days before or after the sale will make the loss ineligible for tax purposes.

Wash Sale Penalty

A wash sale itself is not illegal. Claiming the tax loss on a wash sale is, however, illegal. The IRS does not care how many wash sales an investor makes during the year. On the other hand, it will disallow the losses on any sales made within 30 days before or after the purchase.

If the IRS determines that a transaction violates the Wash Sale Rule, it will disallow the loss deduction on the original sale. However, the loss will be added to the cost basis (the original purchase price for tax purposes) of the purchased security. The IRS also adds the sold security’s holding period to the newly purchased security.

There may, however, be an advantage to this “penalty,” in that, when eventually sold, the loss on the repurchased security may be even larger than the original loss for a greater tax advantage. Similarly, the extended holding period can turn the loss or gain from short-term to long-term. For the moment, though, the loss is disallowed on the original sale.

What Happens to Your Loss?

When a loss is denied as a wash sale, the loss is added to the cost basis of the repurchased security. This means that the investor will recoup the loss if the security is again sold at a loss calculated from the higher cost basis.

The Bottom Line

The IRS created the Wash Sale Rule to prevent investors from selling securities for the sole purpose of claiming a tax loss while immediately repurchasing the same security.

Read the original article on Investopedia.

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