What is a Wash Sale
A wash sale is a transaction in which an investor sells a losing security to claim a capital loss, only to repurchase it again (or purchase an identical security) within 30 days of the sale. Wash sales are a method investors employ to try and recognize a tax loss without limiting their exposure to the security.
BREAKING DOWN Wash Sale
When investors realize a capital loss from selling their investments, the loss can be used to offset any capital gains to reduce an investor’s tax liability. For example, let’s assume an investor has a $15,000 capital gain from the sale of ABC stock. He falls in the highest tax bracket and so will have to pay 20% capital gains tax, or $3,000, to the government. But let’s say he sells XYZ security for a loss of $7,000. His net capital gain for tax purposes will be $15,000 - $7,000 = $8,000, which means he’ll have to pay only $1,600 in capital gains tax. Notice how the realized loss on XYZ reduces the gain on ABC and, hence, reduces the investor’s tax bill.
However, if the investor repurchases XYZ stock or a stock identical to XYZ within 30 days of the sale, the transaction outlined above is known as a wash sale. To be more specific, a wash sale involves selling a security at a loss and repurchasing the same security, or one that is substantially identical, within 30 days before or after the sale. If the transaction outlined above is considered a “wash” by the Internal Revenue Service (IRS), the investor would not be allowed any tax benefits. The anticipated tax loss will also be disallowed if an individual sells a security, and his/her spouse or a company controlled by the individual buys a substantially equivalent security. Furthermore, repurchasing a substantially identical security to the one sold can also be done by purchasing an options contract. The sale of options, which are quantified the same way as stocks, at a loss and reacquisition of identical options in the 30-day timeframe would also fall under the definition of a wash sale.
The effectiveness of a wash sale has been greatly diminished with the implementation of the IRS 30-day wash-sale rule, where a taxpayer cannot recognize a loss on an investment if that investment was purchased within 30 days of sale (before or after sale). In effect, the wash sale period is actually 61 days, consisting of 30 days before to 30 days after the date of sale. For example, 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 security was repurchased within the limited time interval. However, if the investor purchases IBM, another tech stock, on December 25, the wash sale rule does not apply. This is because the IRS does not consider securities of one company substantially identical to those of another.
In addition, the IRS does not ordinarily consider bonds and preferred stock of an issuing company to be substantially identical to the company’s common stock. However, there may be circumstances in which preferred stock, for example, may be considered substantially identical to the common stock. This would be the case if the preferred stock is convertible into common stock without any restriction, has the same voting rights as the common stock, and trades at a price close to the conversion ratio.
The good news is that any loss realized on a wash sale is not completely lost. Instead, the loss can be applied to the cost basis of the most recently purchased substantially identical security. Not only does this addition increase the cost basis of the purchased securities, it also 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 sale securities is added to the holding period of the repurchased securities, which increases an investor’s odds of qualifying for the 15% favorable tax rate on long-term capital gains.