Wash Sales

The last critical piece of tax code pertaining to investment income that you need to know concerns wash sales: dumping securities that are now worth less than you paid for them, taking the loss for tax purposes, and then buying them back immediately at the low cost. The IRS is wise to that old shell game. It is illegal. Don't do it.

The IRS has a 30-day wash-sale rule, where a taxpayer cannot recognize a loss on an investment if that investment (or a similar investment) was purchased within 30 days before or after the sale, including the actual day of the sale.

For example, if you bought 100 shares of XYZ on Nov 1 and then sold 100 shares of XYZ on Nov 28 at a loss, the loss deduction would not be allowed. Similarly, short selling ABC on Nov 15 and then closing the position by buying ABC on Dec 10 does not permit a deduction.

"Substantially Identical" Securities
In most circumstances, shares from different companies, or bonds and preferred shares of the same company are not considered "substantially identical" under IRS rules. However, the IRS warns that individuals must consider more than the security itself in determining whether or not it is considered identical, such as whether the shares are related due to a reorganization of the underlying company.

In general, convertible bonds, convertible preferred shares, and call or put options that can be converted into common shares that have been bought or sold by the investor are considered substantially identical.

Excluded from the wash sale rules are:

  • Any loss arising from a section 1256 contract, which includes regulated futures contracts, foreign currency contracts, nonequity options, dealer equity option, or dealer securities futures contract.
  • In most cases, nonconvertible securities.


Look Out!
The IRS also considers similar securities that are bought and sold within the 61 day window. For example, an investor purchased ABC stock on October 15th for $40 and then sold it on October 31st for $35. A few days later, on November 5th the investor then purchased a call option on ABC stock. Consequently, this investor would not qualify for a tax deduction for the loss incurred on their purchase and sale of ABC stock, and would have to add $5 ($40-$35) to the cost of the option.


The IRS provides an excellent publication detailing the rules and examples of various situations that can arise. We strongly recommend a read of the following information in IRS Publication 550 (2005), Investment Income and Expenses
.

Rules Regulating SROs

Related Articles
  1. Investing

    Explaining RBC's Wash Trade Accusations

    On April 2, U.S. regulators accused RBC of operating a wash trading scheme. Find out what this means.
  2. Managing Wealth

    Explaining the Wash Sale Rule

    The wash sale rule is a provision that prohibits taxpayers from creating artificial losses by selling stocks and bonds at a loss, then repurchasing them.
  3. Financial Advisor

    Washing Trades In A Canadian Registered Account

    For Canadian RRSP accounts, washing same-day trades and using money market funds to bridge the gap over a multi-day trading period saves investors the exchange fee and will help their bottom ...
  4. Investing

    What is the Price-to-Sales Ratio?

    The price-to-sales ratio is an indicator of the value placed on each dollar of a company’s sales or revenues.
  5. Financial Advisor

    Top Tips for Deducting Stock Losses

    Investors who know the rules can turn their losing picks into tax savings. Here's how to deduct your stock losses.
  6. Managing Wealth

    What is the Effective Tax Rate?

    The effective tax rate is the average rate at which an individual or corporation is taxed per year.
  7. Investing

    Leverage Your Returns With A Convertible Hedge

    Find out how you can maintain your income stream by using this type of bond strategy.
  8. Investing

    Harvest Your Tax Losses Before Year-End

    You could have some losses in your taxable accounts that you can harvest for a tax deduction.
  9. Investing

    What's Share Capital?

    Share capital, also called equity financing, is the total amount of money and property a company has received for selling its shares to shareholders.
Frequently Asked Questions
  1. How can the price-to-earnings (P/E) ratio mislead investors?

    A low P/E ratio doesn't automatically mean a stock is undervalued, just like a high P/E ratio doesn't necessarily mean it ...
  2. What are the main differences between compound annual growth rate (CAGR) and internal rate of return (IRR)?

    The compound annual growth rate (CAGR), measures the return on an investment over a certain period of time. The internal ...
  3. What are the differences between gross profit and gross margin?

    Learn how gross profit and gross margin are calculated and how each is used in fundamental analysis. Generally, these numbers ...
  4. How do I calculate the adjusted closing price for a stock?

    When trading is done for the day on a recognized exchange, all stocks are priced at close. The price that is quoted at the ...
Trading Center