The ability for taxpayers to deduct investment losses against capital gains can encourage many to realize losses on their stocks and securities at the end of a tax year. Taxpayers must be careful that they are not participating in wash sales when making adjustments to their portfolios or they may find their deductions disallowed.
Wash Sales: It's All About Staying Clean
If an investor wishes to liquidate a security and realize a loss in order to deduct it against capital gains, that investor must make sure that he or she is washing his or her portfolio clean of that position and not adding in a substantially identical position within 30 days before or after the sale. According to the U.S. Securities and Exchange Commission, if a taxpayer buys an identical stock or security within the 30 days before or after the sale that creates the loss, then the loss is not deductible. Additionally, if the taxpayer buys a contract or option on an identical security within that same period, then his or her loss will not be deductible.
IRS Publication 550 states that, in order to avoid triggering the wash sale, an investor must also avoid buying a substantially identical position inside of his or her Traditional or Roth IRA. This is an important note because, generally speaking, losses within an IRA are confined to the IRA and cannot be deducted against capital gains, except in special circumstances. Investors who understand this may believe that wash sale rules would not apply if the substantially similar stock is sold from an account that is not an IRA and repurchased inside an IRA, but that would be incorrect.
There are other outlying circumstances that can trigger the wash sale rule. If a spouse or corporation under the investor's control purchases a substantially identical security during the 30 days before or after the sale that can trigger the wash sale. It doesn't always require an actual purchase to disallow a loss deduction. Employees who are given shares of corporate stock as a bonus may not be able to deduct losses if they receive additional bonuses within the 30 days surrounding the sale.
It's even possible that some mutual fund purchases may run afoul of the wash sale rules. Funds that are modeled after the same index could be considered substantially identical, even if the fund family isn't.
When a Deduction Is Disallowed
IRS Publication 550 states that a disallowed loss will be added to the cost basis of the new security. This will essentially offset gains later and may even create losses upon the security's future sale. In addition, for capital gains purposes, the holding period for the new security will include that of the security sold.
The Concept of Substantial Identicalness
If you wish to avoid triggering the wash sale rule, it's important to understand what the IRS sees as substantially identical. Examples given in Publication 550 include a corporation that reorganizes and has a successor. In that case, the securities of both organizations could be considered substantially identical. Another example given is preferred stock that is convertible into common stock.
Working Around the Wash Sale Rule
There are a couple of acceptable workarounds that could help you maintain all or part of your deduction while purchasing substantially identical securities. The first is that a partial deduction can be taken if more stock is sold then repurchased within the 60 days surrounding the sale. For example, if you own 1,000 shares of XYZ and you sell them all at a loss then repurchase 200 shares you may still be entitled to deduct the loss of the net 800 shares sold. Since the disallowed loss and the other 200 shares will be added to the cost basis of the newly purchased 200 shares, the rest of your loss doesn't exactly disappear, it is simply delayed.
Another workaround is just to purchase substantially identical shares outside of the 30-day periods before or after the sale, resulting in losses.
The Bottom Line
The wash sale rule can result in the disallowance of a much-needed deduction. For this reason, it's imperative that you understand what is considered "substantially identical" and follow the above suggestions to work around the wash sale rule.