The Wash Sale Rule for Deferring Capital Losses
Capital losses on investment transactions may be deferred
Capital losses can be a good thing at tax time. How can a loss be advantageous? Because when your capital losses exceed your capital gains, you can take a tax deduction for the difference. This deduction can offset capital gains as well as other income like wages, up to certain limits.
But a capital loss on an investment can end up being deferred to a later date under some circumstances. If an investor repurchases the same or a substantially identical security within 30 days before or after selling the original at a loss, something called the wash sale rule comes into play.
An Example of a Wash Sale
Suppose Joe has a taxable brokerage account that holds 50 shares of XYZ stock with a cost basis of $500 because he bought the stock when it cost $10 per share. The stock is worth only $5 per share on July 31, and he sells all 50 shares. It produces a capital loss of $250.
If Joe purchases new shares in XYZ within 30 calendar days before the sale or up to 30 calendar days after the sale, his capital loss is deferred until he sells these new, replacement shares.
Wash Sale Rule Defined
A wash sale consists of two transactions: An investment is sold at a loss, and one of three purchase transactions occur within 30 days before or after the date of sale:
- Buying or otherwise acquiring substantially identical stock or securities
- Buying a contract or option to buy substantially identical stock or securities
- Buying substantially identical stock for your individual retirement account.
The wash sale rule is also triggered if one person sells an investment at a loss and that person's spouse or a corporation controlled by him buys the same investment within the wash sale time period.
The wash sale time period is 61 days – Day X plus 30 days preceding that date and 30 days after that date.
Deferring Losses until the Replacement Investment is Sold
If an investor purchases the same or a substantially identical investment within the 61-day wash sale period, the loss from the sale transaction is disallowed, and the amount of the loss is added to the cost basis of the replacement investment. This functions to defer the loss until a later date when the replacement investment is eventually sold off. The replacement investment also keeps the same holding period as the disallowed loss.
Let's say Joe sells those 50 shares of XYZ stock for $5 per share on July 31, incurring the $250 loss. Now he purchases 50 shares of XYZ stock on August 15 when the stock is trading at $6 per share. August 15 is within the 61-day period, so Joe's $250 loss is a wash sale. It's disallowed, and Joe's basis in the replacement shares increases by $250. Joe's adjusted basis in the replacement shares is $550: 50 x $6 + $250. In other words, Joe's actual basis in the shares, which would be 50 x $6 or $300 is adjusted and increased by the $250 loss that was not allowed. In this example, Joe's loss is a "wash" just as though he held his original shares without selling.
Reporting Wash Sales on Form 8949
All investment sales are reported on Form 8949 then summarized on Schedule D.
The IRS requires that the transaction is identified with code "W" in column (b), and the loss adjustment must be reported in column (g) when a particular sales transaction is a wash sale. Wash sale adjustments were reported on a second line immediately underneath the sale to show the adjustment before 2011.
Adjusting the Cost Basis
By adding the wash sale loss to the cost basis of the replacement shares, the loss is deferred and can be recouped when the replacement shares are sold. The IRS advises, "If your loss was disallowed because of the wash sale rules, add the disallowed loss to the cost of the new stock or securities. The result is your basis in the new stock or securities. This adjustment postpones the loss deduction until the disposition of the new stock or securities. Your holding period for the new stock or securities includes the holding period of the stock or securities sold."
The Same or Substantially Identical Securities
Two investments are the same if they are exactly identical or if they are "substantially" identical. It is easy to see when you're dealing with the same stock, mutual fund or bond. It's a bit harder to identify when two investment securities are very similar.
Passively-managed index mutual funds based on the same underlying market index may be substantially identical to each other, warns Kaye Thomas in his blog "Substantially Identical Securities" on Fairmark.com. On the other hand, two bonds issued by the same issuer might not be substantially identical. Bonds having different maturity dates, interest rates or other features are generally not considered to be substantially identical to each other. "In determining whether stock or securities are substantially identical," the IRS says, "you must consider all the facts and circumstances in your particular case."
Wash Sale Triggered by Repurchasing an Investment through an IRA
Selling an investment at a loss in a taxable account and purchasing the same or substantially identical investment in an IRA-based account is a wash sale. This type of transaction would also result in the permanent disallowance of the capital loss rather than simply a deferral to a later date.
How to Avoid Wash Sales
In general, wash sales are best avoided whenever possible to preserve the tax benefit of the capital loss. They can be avoided by simply waiting until the 61-day wash sale period is over before repurchasing exactly the same investment. If you want to stay invested in a similarly-performing investment, you can purchase securities that are similar but not substantially identical to the investment you sold off.
When a Wash Sale Might be Beneficial
Sometimes having a wash sale might turn out to be advantageous. You might find that your capital gains will currently be taxed at the zero-percent tax rate, in which case a capital loss is offsetting that capital gain would result in no tax savings. You could then purchase the same or substantially identical securities to defer the loss to another year when it might be more beneficial to you.