DEFINITION of 'Wash'

A wash is a series of transactions that results in a zero net sum gain. This can be the result of a loss on one investment and a gain on another or it can be the result of buying and selling the stock of a single company. Investors should be aware of the fact that there are tax consequences to certain wash situations.

A wash is sometimes referred to as a break-even proposition.

BREAKING DOWN 'Wash'

A wash involves two transactions that cancel each other out, effectively creating a break-even position. If a company sells $25,000 worth of merchandise that cost it $25,000 to produce, a wash results. Likewise, an investor that loses $5,000 from the sale of an investment and gains $5,000 from the sale of another has washed the transaction.

Tax rules and prohibitions regarding wash sales prevent an investor from selling a security at a loss and repurchasing the same or substantially identical security shortly before or after. To be more specific, the IRS wash sale rule prohibits investors from claiming losses on an investment if they repurchase it (or something very similar) within 30 days of selling it. The wash sale period is actually 61 days – 30 days before to 30 days after the date of sale. Assume an investor buys 100 shares of MSFT stock on November 1 for $10,000. On December 15, the value of the 100 shares has declined to $7,000, so she sells the entire position to realize a capital loss of $3,000 for tax deduction purposes. On December 25 of the same year, she buys 100 shares of MSFT again to re-establish her position in the stock. The initial loss cannot be claimed for tax purposes since the same security was repurchased within the limited time interval.

However, the loss realized from a wash is not completely lost. Instead, the loss can be applied to the cost basis of the most recently purchased substantially identical security. This addition increases the cost basis of the purchased securities and reduces the size of any future taxable gains as a result. Thus, the investor still receives credit for those losses, but at a later time. Also, the holding period of the wash securities is added to the holding period of the replacement securities, increasing an investor’s odds of qualifying for the 15% favorable tax rate on long-term capital gains.

In addition to the tax consequences, some wash sales are illegal. For example, if an investor buys a stock with one brokerage firm, he or she cannot legally sell it through another brokerage for the purpose of stimulating investor interest. This is known as a "pump and dump" scheme.

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