The Wash Sale Rule: Six Things to Know to Avoid Tax Pitfalls

Be aware of the wash sale rule enforced by the IRS. The rule is important for investors reassessing their market positions and looking to sell and repurchase declining stocks to offset losses.

Disallowed losses are a potential tax pitfall of violating the wash sale rule, so here are six key things you need to know.

1. What is the wash sale rule?

The wash sale rule states that if you buy or acquire a substantially identical stock within 30 days before or after you sold the declining stock at a loss, you generally cannot deduct the loss.

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Essentially, a wash sale occurs when you sell a security at a loss and then purchase the same security again in a short period.

Note: Losses can offset same-year gains that can ultimately reduce capital gains taxes. Additionally, remaining losses can be deducted from ordinary income (up to $3,000) or carried over to the following tax year. As a result, many people opt to sell securities at a loss to reduce taxable gains, a technique commonly known as tax loss harvesting.

However, the IRS doesn’t like investors to use "manufactured" losses to claim tax breaks. If you sell a stock at a loss and quickly buy it back or keep investing in it after buying it back, the IRS generally won’t allow you to write off the loss on your federal tax return.

Let's consider an example. Suppose you bought 50 shares of a fictional JustaTissueBox stock for $100 per share, and its value dropped to $80 per share.

• You decided to sell all your shares at a loss of $1,000.
• However, two weeks later, the stock's value dropped further to $50 per share, and you bought back 50 shares for $2,500.
• Unfortunately, you cannot claim the $1,000 capital loss on your tax return for that year because the second purchase was a wash sale.

2. : Disallowed wash sale loss: What happens when you have a wash sale

If you experience a wash sale, the capital loss disallowed by the IRS is included in the cost basis of the replacement stock. So, if you sell the replacement stock later, any taxable gain will be smaller, and any deductible loss will be larger.

Additionally, the holding period of the new stock now includes the holding period of the original stock. As a result, when you sell the new stock, the gain may be taxed at lower long-term capital gains tax rates.

3. How to avoid the wash sale rule 

If you want to avoid the IRS disallowing your loss due to the wash sale rule, you have a few options.

• One choice is to hold off on repurchasing the same or very similar stock that you sold. Keep in mind that the wash sale rule goes into effect 30 days before and after the sale, so you have a 61-day window to avoid buying the same stock.
• Alternatively, if waiting 61 days isn't feasible, you can purchase a security that is not substantially identical to the one you recently sold.

The challenge with the second option is that the term “substantially identical” hasn’t been defined by Congress or the IRS. So, what’s considered substantially identical for the wash sale rule will largely depend on the facts and circumstances of your transaction.

4. Wash sale in stocks: Examples 

If you are trying to figure out if the IRS might disallow some of your capital losses, IRS Publication 550 contains some wash sale rule examples that could help.

• Generally, stocks of one corporation are not considered substantially identical to those of another corporation.
• However, in certain situations, like a reorganization, those stocks could be considered substantially identical.

According to the IRS, a corporation's bonds and preferred stock are usually not considered too similar to its common stock. But, if the preferred stock can be turned into common stock, has the same voting rights, or is limited in the same way in terms of dividends, then it would be considered substantially identical.

What about your spouse’s stock purchases? The IRS says that a wash sale exists if your spouse or a corporation you control purchases substantially identical stock within the wash sale rule 61-day period.

What about ETFs and the wash sale rule? Things can get a little complicated when it comes to ETFs that track the same index.

For example, you might think selling a Vanguard S&P 500 ETF shares and immediately buying an SPDR S&P 500 ETF is a way to harvest a tax loss without changing your investment. However, because both ETFs track the same index, the IRS might consider them "substantially identical." While there are slight differences in how these ETFs are managed and their fees, it's often best to play it safe.

Some experts suggest switching to an ETF that tracks a different index, such as a total stock market ETF. But remember, the IRS looks at each situation individually, so when in doubt, it's always a good idea to consult with a tax professional who knows your situation.

5. What the wash sale rule applies to

The wash sale rule applies to most securities, including stocks and options, bonds, mutual funds, and exchange-traded funds (EFTs). But the wash sale rule doesn't currently apply to cryptocurrency. This is partly because the IRS classifies crypto as property, not a security. So, you can claim the capital loss if you are selling crypto for a loss and immediately rebuying it.

So, at the moment, crypto investors have a tax loophole known as the "wash sale rule crypto loophole." (This essentially allows them to claim tax benefits for losses that may not be genuine.) However, investors in other securities are subject to the wash sale rule.

What about retirement accounts? It's worth noting that the wash sale rule extends beyond taxable investment accounts. The rule can come into play with retirement accounts.

For instance, if you sell a security at a loss in your regular brokerage account and then buy the same or substantially similar security in your IRA within 30 days or after the sale, the wash sale rule is an issue.

You could lose the ability to claim the tax loss on your current year's return and wouldn't be able to adjust the cost basis of the repurchased security in your retirement account.

6. How to report a wash sale on your return

If you need to report losses from wash sales, you can use IRS Form 8949 and Schedule D. Form 8949 will help you compare the amounts reported on Forms 1099B or 1099S, while Schedule D will show the overall gain or loss from the transactions reported on Form 8949.

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

Wash sale rule: Bottom line 

Before selling and repurchasing stocks that decreased in value, you should seek trusted advice experts who are knowledgeable about the tax implications involved.

Also, review IRS guidelines, in Publication 550, to understand which losses might be disallowed due to the wash sale rule.

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