The Wash Sale Rule for Deferring Capital Losses
Capital losses on investment transactions may be deferred
It's never fun to lose money on an investment, but capital losses can be a good thing at tax time because you can deduct those losses from your capital gains. If your capital losses exceed your capital gains, your deduction can offset other income, such as wages from your job.
However, if you aren't careful, you can end up negating the benefits of a capital loss. If you violate something called the "wash sale rule," you delay your ability to deduct your capital losses, and you could lose out on the deduction forever.
The Wash Sale Rule Defined
A wash sale consists of two transactions. The first transaction is when a trader closes a position at a loss. For instance, a person may have bought a stock for $10, then that person later sells that stock for $5. That produces a capital loss of $5.
At this point, that $5 capital loss is still tax-deductible, but it's the second transaction that negates the tax benefits of the loss. The second transaction must occur within 30 days of the first transaction, and it can be any of the four following 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 individual retirement account (IRA or Roth IRA)
The wash sale rule is also triggered if a person sells an investment at a loss and that person's spouse, or a corporation controlled by them, buys the same investment within 30 days.
The time period is not confined to the 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 and 30 days after that date.
An Example of a Wash Sale
The stock is worth only $5 per share on July 31, and he sells all 50 shares for a total of $250. Since Joe paid $500 for the shares and only earned $250 from selling them, the trade produced a capital loss of $250.
Now, let's say that Joe purchases new shares in XYZ on August 15. Since the transaction falls within 30 days of July 31, the wash sale rule has been triggered. This has two ramifications. First, the capital loss from the July 31 sale is deferred. Secondly, his cost basis on his new XYZ position is adjusted.
The same rule would apply if Joe 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
When the wash sale rule has been triggered, the amount of the investor's loss is added to the cost basis of the replacement investment. This defers the loss until a later date when the replacement investment is eventually sold off.
The holding period from your original investment will be added to the holding period of your replacement investment.
Returning to the Example Scenario
Joe sold 50 shares of XYZ stock for $5 per share ($250 total) on July 31, incurring a $250 loss. He purchased 50 shares of XYZ stock on August 15 for $6 per share ($300 total). August 15 is within the 61-day wash sale period, so Joe's $250 loss on July 31 was a wash sale, and his loss is added to the cost basis of his new investment.
Joe's adjusted basis in the replacement shares is now $550—$300 from his August 15 purchase combined with his $250 loss from his July 31 sale. In this example, Joe's loss is a "wash," just as though he held his original shares without selling.
The tax benefit of Joe's capital loss isn't gone forever, it's just deferred. By applying the losses to his adjusted cost basis, the loss on the original investment will be taken into account when he sells his replacement shares.
Repurchasing Substantially Identical Securities in an IRA
Investors should particularly try to avoid violating the wash sale rule by purchasing substantially identical securities in an IRA. 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.
What Is a "Substantially Identical" Security?
Unfortunately, tax law doesn't clearly define what makes one security "substantially identical" to another. The IRS 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 know the security is substantially identical when you're dealing with the same stock, mutual fund, or bond. In the example scenario, Joe sold XYZ stock and bought XYZ stock, so they're obviously substantially identical securities. 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. However, selling a single company's stock and then buying an index fund that includes that stock wouldn't violate the wash rule.
Two bonds issued by the same issuer might not be substantially identical if they differ on features like maturity dates or interest rates. Preferred stock may or may not be substantially identical to common stock in the same company, but it depends on whether the preferred shares can be converted into common shares, and whether they share features like voting rights.
When Wash Sales Can Be Beneficial
While it's usually beneficial to avoid wash sales, there are situations in which an investor would purposefully trigger the wash sale rule.
For instance, if you took an extended break from work one year, your lower-than-usual income may bump you into a lower tax bracket. You might find that your capital gains will be taxed at the 0% tax rate that year. Therefore, there's no point in offsetting your capital gains by applying the tax benefits from your capital losses. You may 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 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.
Securities and Exchange Commission. "Wash Sales." Accessed April 14, 2020.
Internal Revenue Service. "Publication 550: Investment Income and Expenses (Including Capital Gains and Losses)," Page 56. Accessed April 14, 2020.
Internal Revenue Service. "Internal Revenue Bulletin: Rev. Rul. 2008-5." Accessed April 14, 2020.
Fidelity Investments. "Tax Rules for Losses on ETFs." Accessed April 14, 2020.
Internal Revenue Service. "Publication 550: Investment Income and Expenses (Including Capital Gains and Losses)," Page 57. Accessed April 14, 2020.
Internal Revenue Service. "2019 Instructions for Form 8949." Accessed April 14, 2020.