Risk and Tax Considerations - Wash Sales and Substantially Identical Securities
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.
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.
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