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 because you can sometimes take a tax deduction for the difference when your losses exceed your capital gains. This deduction can offset other income, such as wages, in addition to capital gains.
But a capital loss on an investment can end up being deferred to a later date under some circumstances. Something called the "wash sale rule" comes into play when an investor repurchases the same or a substantially identical security within 30 days before or after selling the original security at a loss.
The Wash Sale Rule Defined
A wash sale consists of two transactions: An investment sold at a loss, and one of three purchase transactions that 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 purchase substantially identical stock or securities
- Buying substantially identical stock for your individual retirement account (IRA)
The wash sale rule is also triggered if one person sells an investment at a loss and her spouse or a corporation controlled by her buys the same investment within the wash sale time period.
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: Day X plus 30 days preceding 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. It produces a capital loss of $250: $500 less the 50 shares at $5 each.
Now let's say that Joe purchases new shares in XYZ on August 15, within 30 days of selling his old shares on July 31. His capital loss will be deferred until he sells these new, "replacement" shares.
The same rule would apply if Joe purchased the new shares at any time between July 1 and July 31, or 30 days before the sale.
The amount of the investor's loss is added to the cost basis of the replacement investment when the loss from the sale transaction is disallowed because he purchased the same or a substantially identical investment within the 61-day wash sale period. This defers 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.
Adjusting the Cost Basis
Joe sold those 50 shares of XYZ stock for $5 per share on July 31, incurring the $250 loss. He purchased 50 shares of XYZ stock on August 15 when the stock was trading at $6 per share. August 15 is within the 61-day period, so Joe's $250 loss was 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 now $550: 50 x $6 + $250. Joe's actual basis in the shares, which would be 50 x $6 or $300, is adjusted and increased by the $250 loss that wasn't allowed. In this example, Joe's loss is a "wash" just as though he held his original shares without selling.
The loss is deferred and can be recouped when the replacement shares are sold by adding the wash sale loss to the cost basis of the replacement shares. The IRS says:
"If your loss was disallowed because of the wash sale rule, 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."
"Substantially Identical" Securities
Two investments are obviously the same if they are exactly identical, such as in the case of Joe selling XYZ stock, and purchasing XYZ stock. It's easy to see when you're dealing with the same stock, mutual fund, or bond, but it's a bit harder to identify when two investment securities are very similar. The tax term for this is "substantially" identical.
Passively-managed index mutual funds based on the same underlying market index can be substantially identical to each other, but 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.
The IRS states:
"In determining whether stock or securities are substantially identical, you must consider all the facts and circumstances in your particular case."
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 also considered to be a wash sale, but the rules in this case are a bit stricter. This type of transaction would 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 or a similar investment.
Another option is to purchase securities that are similar but not substantially identical to the investment you sold off if you want to stay invested in a similarly-performing investment.
A Wash Sale Can Be Beneficial
Sometimes having a wash sale might turn out to be advantageous. You might find that your capital gains will be taxed at the 0% tax rate in a given year, so offsetting a capital gain with a capital loss 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.
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 (b), and the loss adjustment must be reported in column (g). Wash sale adjustments were reported on a second line immediately underneath the sale to show the adjustment before 2011.
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 an exact symbol per account, so transactions can and often do fall through the cracks. The wash sale rule applies to any and all purchases and sale you make, even through separate accounts, so you'll want to keep your own accurate records.
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.
Note: Tax laws change periodically and you should always consult with a tax professional for the most up-to-date advice. The information contained in this article is not intended as tax advice and it is not a substitute for tax advice.