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What is the 'Wash-Sale Rule'

The wash-sale rule is an Internal Revenue Service (IRS) regulation that prohibits a taxpayer from claiming a loss on the sale or trade of a security in a wash sale. The rule defines a wash sale as one that occurs when an individual sells or trades a security at a loss, and within 30 days before or after this sale, buys a “substantially identical” stock or security, or acquires a contract or option to do so. A wash sale also results if an individual sells a security, and the spouse or a company controlled by the individual buys a substantially equivalent security.

BREAKING DOWN 'Wash-Sale Rule'

The intent of the rule is an effort by the IRS to prevent taxpayers from claiming artificial losses. Conversely if a taxpayer were to see a gain by selling securities and within 30 days buy identical replacement securities, the proceeds from that transaction would still be taxable. The sale of options, which are quantified the same ways as stocks, at a loss and reacquisition of identical options in the 30 day timeframe would also fall under the terms of the wash-sale rule.

What Constitutes a Wash Sale

Stocks or securities of one company are generally not considered substantially identical by the IRS to those of another. As well, bonds and preferred stock of a company are also ordinarily not considered 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.
If the loss is disallowed by the IRS because of the wash sale rule, the taxpayer has to add the loss to the cost of the new stock, which becomes the cost basis for the new stock. For example, consider the case of an investor who purchased 100 shares of Microsoft for $33, sold the shares at $30, and within 30 days bought 100 shares at $32. In this case, while the loss of $300 would be disallowed by the IRS because of the wash sale rule, it can be added to the $3,200 cost of the new purchase. The new cost basis therefore becomes $3,500 for the 100 shares that were purchased the second time, or $35 per share.


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