A wash sale is a transaction in which an investor sells a losing security in order to claim a capital loss, only to repurchase it (or a substantially identical security) again within 30 days of the sale. Some investors use this technique to try to realize a tax loss without limiting their exposure to the security.
The Internal Revenue Service (IRS) established the wash-sale rule to discourage selling a security at a loss in order to take advantage of a tax deduction. The rule prohibits selling a security at a loss and repurchasing the same security, or one that is substantially identical, within 30 days either before or after the sale, or acquiring an option to do so.
Wash Sale in Action
For example, say you buy 100 shares of XYZ technology stock on Nov. 1 for $10,000. On December 15, the value of the 100 shares has declined to $7,000. So, you sell the entire position to realize a capital loss of $3,000 in order to claim a tax deduction. Then on Dec. 25 of the same year, you repurchase the 100 shares of XYZ tech stock back again to reestablish your position in the stock. According to the wash-sale rule, the loss would not be allowed, as you would have repurchased the security within the 30-day limit.
Can You Avoid the Wash-Sale Rule?
There are simple techniques that you can use to keep yourself in the market for a particular security until the wash-sale period has expired. For example, if you sold your 100 shares of XYZ tech stock on Dec. 15, you then could have purchased a technology exchange-traded fund (ETF) or tech mutual fund to retain some holdings in the technology sector—although this strategy would not replicate the initial position exactly because of the different financial instruments involved. Then if you desired, when the 30-day period passed, you could go ahead and sell the mutual fund or ETF and once more repurchase your XYZ stock. Of course, you may always repurchase the stocks prior to the end of the 30-day period, but then you would not be able to realize a tax deduction from your initial loss.