Capital losses can actually be a good thing at tax time because you can deduct them from your capital gains, potentially reducing your tax bill. Your deduction can offset other income, such as wages from a job, when your capital losses exceed your capital gains.
But you can negate the benefits of a capital loss if you aren't careful. You'll delay your ability to deduct your capital losses and you could lose out on the deduction forever if you violate the "wash sale rule."
The Wash Sale Rule Defined
A wash sale consists of two transactions. The first occurs when a trader closes a position at a loss. You might have bought a stock for $10, then you later sold it for $5. You have a capital loss of $5.
That $5 capital loss is tax-deductible, but a second transaction can erase the tax benefits of the loss if it occurs within 30 days of the first transaction and it's any one of four transactions:
- Buying substantially identical stock or securities
- Acquiring substantially identical stock or securities in a fully taxable trade
- Acquiring a contract or option to purchase substantially identical stock or securities
- Acquiring a substantially identical stock for your IRA or Roth IRA
The wash sale rule can also be triggered if you sell an investment at a loss and your spouse or a corporation controlled by you buys the same investment within 30 days.
The time period isn't confined to a calendar year. You can't sell on December 15 and expect that the wash sale period will terminate in 16 days when a new year begins.
The wash sale time period totals 61 days: the day of the first transaction plus 30 days before that date plus 30 days after that date.
What Is a Substantially Identical Security?
Unfortunately, tax law doesn't clearly define what makes one security "substantially identical" to another. The IRS simply states:
"In determining whether stock or securities are substantially identical, you must consider all the facts and circumstances in your particular case."
It's easy to tell that a security is substantially identical when you're dealing with the same stock, mutual fund, or bond. They're obviously substantially identical securities if you sold XYZ stock and bought XYZ stock. It's a bit harder to identify when two investment securities are similar, but not entirely identical.
For example, two passively managed index mutual funds based on the same underlying market index can be substantially identical to each other. Selling a single company's stock, then buying an index fund that includes that stock wouldn't violate the wash rule, however.
Investors should particularly try to avoid violating the wash sale rule by purchasing substantially identical securities in an IRA because this type of transaction would result in the permanent disallowance of the capital loss, rather than simply deferring the tax benefit to a later date.
Example of a Wash Sale
Let's say that you have a taxable brokerage account that holds 50 shares of XYZ stock. Your cost basis in the stock is $500 because you bought it at $10 per share.
The stock is worth only $5 per share on July 31, and you sell all 50 shares for a total of $250. The trade produced a capital loss of $250 because you paid $500 for the shares and earned only $250 from selling them.
Now let's say that you purchase new shares in XYZ on August 15. The transaction falls within 30 days of July 31, so the wash sale rule is triggered. This has two ramifications. First, the capital loss from the July 31 sale is deferred. Second, your cost basis on your new XYZ position is adjusted.
The same rule would apply if you purchased the new shares at any time between July 1 and July 31 because the 30-day rule applies to the period before the sale as well.
Deferred Loss and Adjusted Cost Basis
The amount of an investor's loss is added to the cost basis of the replacement investment when the wash sale rule is triggered. This defers the loss until a later date when the replacement investment is eventually sold off.
You sold 50 shares of XYZ stock for $5 per share for $250 total on July 31, incurring a $250 loss, then you purchased 50 shares of XYZ stock on August 15 for $6 per share, or $300 total. August 15 is within the 61-day wash sale period, so your $250 loss on July 31 was a wash sale, and your loss is added to the cost basis of your new investment.
Your adjusted basis in the replacement shares is now $550—$300 from your August 15 purchase combined with your $250 loss from the July 31 sale. Your loss is a "wash" in this scenario, just as though you had held your original shares without selling.
The tax benefit of your capital loss isn't gone forever, but it's deferred. The loss on the original investment will be taken into account when you sell your replacement shares by applying the losses to your adjusted cost basis.
The holding period from your original investment would be added to the holding period of your replacement investment.
When Wash Sales Can Be Beneficial
It's usually best to avoid wash sales, but there are situations in which an investor might purposefully trigger the wash sale rule. It could bump you into a lower tax bracket if your income was lower than usual, and you might find that your capital gains will therefore be taxed at the long-term 0% tax rate that year.
There's no point in offsetting your capital gains by applying the tax benefits from your capital losses in this case. You might then decide to purchase the same or substantially identical securities to defer the loss to another year when it might be more beneficial to you.
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 be identified with code "W" in column (f), and the loss adjustment must be reported in column (g).
It's generally not advisable to rely entirely on your 1099s for reporting purposes. Take your records to a tax professional to make sure you get it right.
Brokers should report wash sales to the IRS on Form 1099-B and provide a copy of the form to the investor, but they're only required to do so per account based on identical positions. This means that transactions can—and often do—fall through the cracks. The wash sale rule applies to any and all transactions, even through separate accounts, so you'll want to keep your own accurate records.
Frequently Asked Questions (FAQs)
Does the wash sale rule apply to gains?
The wash sale rule only applies to capital losses. If you sold stock at a gain and later had another similar transaction with the same or a substantially identical stock, the wash rule would not apply to those exchanges.
Will my capital loss carry over into next year's taxes?
When your capital losses exceed $3,000, they can be carried over into the next year. Before they can be carried over, however, the capital losses must first be used to offset any capital gains from the current year.
What is considered a substantially identical stock option?
The IRS defines stock that comes from the same corporation, or one that has been reorganized, as substantially identical holdings. Knowing how to identify these stocks can help you avoid the wash sale rule.