It is a well-known fact that capital gains taxes significantly lower long-term investing results. Naturally, most investors want to lower their tax bill. Sometimes, investors sell assets that have fallen below the purchase price, allowing them to claim a capital loss.
The IRS, however, has very specific rules on capital losses. By knowing and understanding the wash sale rule, you can make sure that you do not inadvertently run afoul of the law.
- The IRS' wash sale rule prevents an investor from purchasing the same securities they sold (or substantially similar ones) within a 30-day period before or after the sale.
- If you violate the wash sale rule, you won't be able to write off the capital loss on that security on your taxes that year.
- This still may not prevent you from taking those losses in some form in the long term, but there is also a risk of loss if the stock price runs back up before you buy it back.
The Wash Sale Rule Defined
Put simply, the wash sale rule prohibits an investor from claiming a capital loss for tax purposes if they repurchase the stock or security within 30 days.
Specifically, the IRS deems a transaction a wash sale if the investor does the following 30 days before or after a sale:
- Purchases the same investment
- Purchases a substantially similar investment
- Enters into a contract to buy a similar investment
- Acquires a similar stock for an IRA or Roth IRA
The wash sale rule applies for 30 days before and after the transaction, creating a 61-day window.
Imagine an investor unfortunate enough to purchase Lucent Technology stock when it was trading upwards of $70 per share. Over subsequent years before the firm disappeared through mergers and acquisitions, that investor watched accounting scandals, financial trouble, and sales meltdowns wipe the share price down to $1.
Ever the enterprising baron, our investor realizes that if they sell their shares, they can report a capital loss and lower their tax burden. The problem? They believe that Lucent, or the firm that ultimately owns it, will rise from the ashes and return some of the market value which it has lost.
Suddenly, our investor gets a brilliant idea. During the last week of December, they call their broker with instructions to sell their shares in the telecom equipment supplier, locking in the capital loss. Three weeks later, during the first half of January, they ask their broker to repurchase those shares of Lucent. All is well in the world; they locked in the capital loss while holding onto the shares. Seems ingenious, right?
The IRS Is One Step Ahead
The wash sale rule, as you remember, does not allow an investor to claim a capital loss if they repurchase the investment within 30 days. In other words, unless the investor waits until the 30-day period has elapsed, they will not be able to write the off the loss.
To add insult to injury, Lucent may run up during the time they are waiting on the sidelines, increasing the purchase price. In the meantime, the investor will have paid two commissions (one for selling in December and one for repurchasing in January).
The Wash Sale Penalty
What happens if the IRS decides that an investor has violated the wash sale rule? The immediate result is that they won't be allowed to use the loss on that year's tax return to reduce taxable income.
However, they will be able to add the loss to the cost basis of the repurchased investment. The investor can also add the holding period of the original investment to the holding period of the replacement. This may allow them to claim larger losses in the future or qualify for the lower capital gains rate.
How to Get Around the Rule
Couldn’t the investor have waited for the wash sale period to expire then repurchase the shares? As a matter of fact, yes.
As mentioned before, there are several problems with this approach. Besides the double commissions, there is a very real risk that Lucent will run up in the short term causing the investor to repurchase at a higher price that may be significantly more than they planned.
The moral? Only sell if you accept the fact you may not be able to repurchase the shares in the future at the same or lower price. If you are reconciled with this possibility, there’s nothing stopping you.