What is a Wash Sale? A Term You MUST Know
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When a new investor using Robinhood in 2020 made news earlier this year for facing a $800,000 tax bill – after only making $45,000 net – many new investors realized there is more to the stock market than they knew. What happened?
The unidentified 30-year-old investor opened a Robinhood online brokerage account and then began making 10 to 50 trades a day. As a day trader he didn't know the rules as he worked between $200,000 and $2 million in trading volume each day, as reported by Morningstar. What rule? Wash sale rules.
If you have never heard of a wash sale, read this because many first-time investors make a big mistake that can cost them come tax time.
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What is a wash sale?
In simple terms, a wash sale is a way for investors to claim a tax benefit for selling a security at a loss, before buying back the security after a short period of time. This typically occurs at the end of the calendar year, when investors can claim a tax benefit for the capital loss before re-purchasing the security shortly after the start of the new tax year.
The IRS implemented the wash sale rule to limit the benefits of wash sales. This rule prohibits investors from deducting the loss on the wash sale if they buy or otherwise acquire “substantially identical” replacement shares within 30 days before or after a sale.
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How a wash sale works
The IRS defines a wash sale as “a sale of stock or securities at a loss within 30 days before or after you buy or acquire in a fully taxable trade, or acquire a contract or option to buy, substantially identical stock or securities.”
To conduct a wash sale, investors sell a stock or security at a loss. Shortly after selling the security, investors then purchase back the same stock or security. This allows investors to take advantage of the tax benefits of the loss while still retaining ownership of the stock or security in question. Due to the potential tax benefits involved, wash sales are typically conducted at the end of the calendar year.
The main attraction behind wash sales is the opportunity to reduce the amount of capital gains tax or income tax paid. This can reduce the amount of taxes you owe to the IRS. However, since the IRS prohibits claiming wash sales as a loss on your tax return, wash sales should be avoided in most cases.
Why investors conduct wash sales
Investors conduct this type of sale to take advantage of tax incentives. When they sell a security at a loss, they can potentially claim this loss on their tax returns to offset capital gains or lower taxable income.
Capital gains are calculated as the difference between an asset’s cost basis and the current market value. Depending on the holding period, capital gains can be taxed either as long-term capital gains or short-term capital gains. In the case of a wash sale, you can potentially use the loss to cancel out a portion of the capital gains tax you owe. Similarly, you can use the loss to reduce your taxable income by up to $3,000 if you don’t have any capital gains.
However, the IRS has strict rules surrounding wash sales, which bars investors from taking deduct losses from a wash sale unless the loss was incurred in the ordinary course of business. This means that wash sales aren’t actually advantageous to investors in most cases.
How the IRS limits wash sales
Wash sales are a type of disallowed loss according to the IRS. To deter investors from conducting wash sales, the IRS limits investors’ ability to claim tax benefits from wash sales through the wash sale rule. Since investors primarily conduct wash sales because of the associated tax advantages, there’s no incentive to conduct a sale that falls afoul of the wash sale rule.
What is the wash sale rule?
The wash sale rule prohibits investors from claiming the loss from a wash sale in order to take advantage of tax benefits. This includes the sale of stocks, bonds, ETFs, options, and mutual funds from any taxable account. According to the IRS, the wash sale rule applies if you trade or sell stock within 30 days do any of the following to “substantially identical” stock or securities:
- Buy them
- Acquire them in a fully taxable trade
- Acquire a contract or option to buy them
- Acquire them for your traditional or Roth IRA
The wash sale rule applies to any stocks that you or your spouse own in any brokerage account.
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What does “substantially identical” mean?
The IRS specifies that the wash sale rule applies to “substantially identical” security or stock bought or acquired within 30 days of a sale. In the simplest case, this means that the wash sale rule applies whenever you buy the same stock within 61 days before or after the sale.
However, the “substantially identical” definition can also apply in some specialized cases to other stocks. For instance, the stocks and securities of predecessor and successor corporations can be considered “substantially identical” for a wash sale. Similarly, preferred stock may be considered “substantially identical” to common stock in some cases.
In some cases, such as with closely related stocks within the same industry, it can be unclear exactly how the rule applies. If you’re not sure whether or not a stock or security is considered “substantially identical,” you should consult with a tax advisor for tax advice before you buy or sell. You can also consult the IRS Publication 550, which provides information on tax laws and the treatment of investment income and expenses.
Exceptions to the wash sale rule
The wash sale rule only applies to the exact amount of “substantially identical” stock purchased in the 30 days before or after a sale. If you purchase more or less stock than you sold, the wash sale rule may only apply to the number of shares that were part of the initial sale. Because the wash sale rule has a specific time limit, stocks or securities purchased more than 30 days before or after a sale are exempt from the rule.
How to report wash sales on your taxes
If you do conduct a wash sale, you can report it on Schedule D of your tax return using Form 8949. Brokers will typically issue investors a 1099-B form with the details of the wash sale to be used when filing a tax return.
Wash sales vs. tax-loss harvesting: what’s the difference?
Wash sales and tax loss harvesting employ similar strategies to take advantage of the potential tax benefits when you sell a stock or security at a loss. However, wash sales differ in their timing, along with how they are dealt with by the IRS.
A wash sale refers specifically to stocks or securities that are sold and then purchased within 30 days before or after the sale date to claim the loss for tax purposes while still maintaining ownership of the stock or security. There are several strategies to avoid a wash sale while lowering your tax bill.
If you sell a certain stock or security at a loss, you can purchase a similar stock in the same industry without violating the wash sale rule. For example, if you sell a particular stock in the technology sector, you can purchase a similar stock after you sell to maintain an investment in the same industry. As long as the two stocks aren’t “substantially identical,” you’ll still be able to take advantage of the loss to lower your tax rate.
Another way to avoid the wash sale rule is to wait more than 30 days before repurchasing the stocks or securities you sold. Because the wash sale only applies for a fixed period of time, you can repurchase the same stock 31 days or more after the sale.
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- Get up to a $0.18 rebate
- No commission or per-contract fees
High-yield cash
- Earn 5.1% APY*
- No fees. No subscription required.
Bonds
- 6% Yield or more
- Explore thousands of bonds yielding 6%+
The bottom line
While wash sales have tax benefits in theory, in practice the wash sale rule makes it so that taxpayers aren’t able to take advantage of the benefits of wash sales. For this reason, wash sales aren’t advantageous for investors under the current tax code and should be avoided when possible.
Instead of conducting a wash sale, investors can still use the strategy of tax-loss harvesting to lower their tax burden by reducing the number of capital gains or other income subject to taxes.
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Writer
Margaret Wack covers personal finance and small business and has appeared on MoneyUnder30, The Simple Dollar and Interest.com.
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