Beware the IRS Wash Sale Rule

Despite noteworthy gains in the U.S. labor market, 2022 has been fraught with economic uncertainty. Everything from high inflation to steep stock market declines, has spurred some investors to reevaluate their market positions. Maybe you're in that boat — focusing on offsetting losses and weighing whether to sell some declining stocks or other securities. If so, you'll want to tread carefully, so as not to run afoul of the wash sale rule.

What is the Wash Sale Rule?

A wash sale occurs when you sell or trade a security at a loss, and then repurchase or acquire the same security within a short period of time. And it's important to remember that losses can be valuable. First, they can be used to offset any gains during the same year, which reduces your capital gains tax. Then, if you have any leftover losses, you can deduct up to $3,000 of them from your ordinary income. Plus, any remaining losses can be carried over and used for the next tax year. As a result, selling off securities at a loss to reduce other taxable gains or income – commonly referred to as "tax loss harvesting" – is a popular tax planning strategy.

Wash sales can be problematic, though. The IRS doesn’t want investors receiving tax breaks by offsetting gains with "manufactured" losses. In other words, the IRS wants to discourage investors from selling securities solely for the purpose of generating capital losses. Thus, if you quickly repurchase a particular stock after having sold it at a loss, or merely continue your investment in the stock because of the repurchase, the IRS’s stance is that you shouldn't be able to write off the initial loss on your taxes.

That's where the wash sale rule comes into play. Specifically, the rule prohibits you from deducting the loss on a declining stock when you’ve bought or otherwise acquired the same or a “substantially identical” stock 30 days before or 30 days after the initial sale.

For example, imagine you purchased 50 shares of fictional JustaTissueBox stock at $100 per share and that stock declines to $80 per share. So, you sell your 50 shares at a $1,000 loss. However, two weeks after the sale, JustaTissueBox stock drops to $50 per share and you decide to buy 50 shares of the stock back for $2,500. Since the second purchase was a wash sale, you're not allowed to claim the initial $1,000 capital loss on your tax return for that year.

But there may be a silver lining even if you violate the wash sale rule. The disallowed loss is added to the cost basis of the replacement stock. So, when you eventually sell the replacement stock, any taxable gain will be smaller or any deductible loss will be larger. In addition, the holding period applicable to the new stock now includes the holding period for the initial stock. As a result, when you sell the new stock, you'll have a better chance of any gain being taxed at the lower capital gains tax rates for long-term gains.

Cryptocurrency Wash Sale Loophole

The wash sale rule applies to most securities, including stocks and options, bonds, mutual funds, and exchange traded funds (EFTs). Notably, however, the rule doesn't currently apply to cryptocurrency. This is in part because the IRS classifies cryptocurrency as property, not as a security.

So, if you buy crypto, sell it for a loss, and then immediately repurchase it, you'll still be able to claim the capital loss under current law.

This has created a so-called crypto wash sale loophole, where crypto investors are getting tax breaks for losses that sometimes are "manufactured" losses. Meanwhile, investors in stocks and other securities subject to the wash sale rule aren't able to claim similar losses — at least not in the same tax year as the securities were first sold.

Warning: Last year, as part of the Democrats’ Build Back Better legislative package, the House of Representatives proposed changes that would have closed the cryptocurrency wash sale loophole. But that legislation stalled in the Senate. Consequently, for the time being, cryptocurrency remains exempt from the wash sale rule – but keep an eye out for potential changes to this loophole down the road.

Wash Sale Reporting

To report losses from wash sales, you use IRS Form 8949 and Schedule D. Form 8949 is used to reconcile the amounts that were reported to you on Forms 1099B or 1099S. Schedule D shows the overall gain or loss from the transactions reported on Form 8949.

If you are married and are filing jointly, you will need to complete as many copies of Form 8949 as needed to report all the transactions for both you and your spouse. The totals from all the Forms 8949 must be included on your Schedule D.

Avoiding the Wash Sale Rule

To avoid having a loss disallowed by the wash sale rule, you can, as the rule essentially points out, wait to purchase, or acquire the same or a substantially identical stock to the one you sold.

However, don't forget that the wash sale rule kicks in 30 days before the sale of the asset and runs 30 days after the sale. So, as a practical matter, you're working with a 61-day period where you have to avoid repurchasing the same stock.

For some investors, the nature of the market, their holdings, or other considerations make waiting to repurchase the security infeasible. In those cases, another way to avoid violating the wash sale rule is to purchase or acquire a security that is not “substantially identical” to the security that was recently sold.

The challenge with this approach is that the term “substantially identical” has not been specifically defined by Congress or the IRS. As a result, what constitutes a substantially identical security for the wash sale rule depends in large part on the individual facts and circumstances surrounding a particular transaction.

IRS Publication 550 contains some general wash sale rule examples. For instance, the IRS says that stocks of one corporation typically aren't considered substantially identical to stocks of another corporation. But the IRS also points out that there could be situations – like a reorganization – where those corporate stocks could be substantially identical.

The IRS also notes that bonds and preferred stock of a corporation generally aren't treated as substantially identical to the same corporation's common stock. However, there are circumstances under which corporate bonds or preferred stock can be treated as substantially identical to the corporation's common stock. For example, if preferred stock can be converted to common stock, carries equivalent voting rights as common stock, or is subject to identical restrictions on dividends as common stock.

Additionally, the IRS clarifies that a wash sale exists if your spouse or a corporation that you control purchases substantially identical stock within the prohibited 61-day period.

In any case, given the wash sale rule, the potential tax implications of tax loss harvesting can be significant. As a result, savvy investors looking to claim capital losses on stocks and other securities will carefully consider the implications of the rule. This could include consulting professionals well-versed in those implications and reviewing IRS guidance in Publication 550 that may shed light on which losses will be disallowed for tax purposes.