Be Careful of the IRS ‘Wash Sale Rules’ to Avoid a Tax Loss in the Stock Market

Ignoring It Could Leave You High and Dry on Tax Day

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Buying and selling is an everyday occurrence in the stock market. So are losses, which means selling an investment at a loss is sometimes inevitable. But whether you are trying to recoup losses without losing great investments, or you simply have seller’s remorse, it is important to avoid the wash-sale rule.

A wash-sale occurs when you sell an investment at a loss and replace it with a “substantially identical” investment 30 days before or after the sale date. Ignoring this rule can lead to a hefty and sometimes unexpected tax bill.

Rules of the Wash-Sale

The wash-sale rule was established to prevent investors from using a crafty trick to get a tax benefit. You can get a tax benefit when selling any investment in a taxable account that has lost money. The wash-sale rule blocks investors from selling investments at a loss, buying the same or substantially identical investment back within 30 days before or after the sale, and claiming the tax benefit from the initial loss.

This rule applies to most investments, including stocks and bonds, options, ETFs, and mutual funds. The rule expressly states that the tax loss will be null and void if you purchase the same “substantially identical” investment within the pre-determined timeframe.

For those seeking a work-around, it is difficult to bypass the rule without penalty. You cannot sidestep the wash-sale rule by selling an investment in a taxable account at a loss and then proceeding to buy it back through a tax-advantaged account.

Working with your spouse to avoid the wash-rule will not allow you to circumvent it either. The IRS specifically states that an investment sold at a loss by one spouse and purchased within the prohibited time parameters by the other spouse also counts as a wash-sale.

The Repercussions of a Wash-Sale

While it is not illegal to make a wash-sale, it is illegal to claim a tax write-off from it. You are free to create as many wash-sales as you like annually. However, you will not be allowed to claim them as deductible losses for tax purposes until you sell your investment and abide by the 30-day window rule. The IRS will suspend your loss, preventing you from claiming a write-off on your tax return. Any income you tried to offset with the wash-sale will incur taxes per normal.

Cost-Basis Implications

If you enact a wash-sale, you will not be allowed to claim the loss on your taxes. You need to add the loss to your cost basis. When you sell the new investment following the guidelines, you will be allowed to claim the loss.

For example, suppose you have 100 shares of a stock that you bought at $20 a share, for $2,000 total. You sell the stock at a loss for $15 a share, and then 15 days later, you re-buy 100 shares at $10 a share. Because you did not abide by the 30-day window, you have enacted a wash-sale.

You will be unable to claim a loss on the first 100 shares, and you will also have to add the disallowed loss onto the new cost basis for the 100 shares bought at $10 a share. Your initial loss of $500 is added to the new purchase of $1,000 ($10 x 100 shares). So your new cost basis would be $1,500.

To reiterate: if you intentionally—or even accidentally—write off your loss from a wash-sale, the IRS will re-adjust your taxes, and you will be charged with the difference.

Deferred, Not Completely Eliminated

Under normal circumstances, the IRS allows investors to write off capital losses, and these losses can be used to offset any capital gains. In a given year, you can write off a net loss of up to $3,000 if the losses are eligible. Wise investors use losses strategically to minimize taxable income via the process of tax-loss harvesting.

However, having a wash-sale prevents you from claiming any write-offs until the investment is sold and not repurchased for at least 30 days. After this time passes, you can repurchase the investment without enacting a wash-sale and its penalties.

Your ability to claim your loss is simply deferred, not completely eliminated. As long as you do not repurchase the investment within the 30-day window, you can claim the loss on your tax return without any wash-sale rule penalty.

Savvy Substitutes

When trying to avoid a wash-sale on an individual stock, consider substituting a mutual fund or exchange-traded fund (ETF) that targets the same industry. In particular, ETFs can be useful to avoid the wash-sale rule when selling a stock for a loss. Some ETFs focus on particular industries or sectors, as opposed to more broad-market ETFs. They provide a savvy way to retain exposure within the industry or sector of the losing stock you sold. ETFs typically hold enough securities to avoid the wash-sale rule, as they are not deemed “substantially identical” to the losing stock.

However, swapping ETFs and mutual funds for other ETFs and mutual funds can be a bit more tricky. The “substantially identical“ guidelines are not particularly clear on what is defined as ”substantially identical.” That classification is determined by the IRS, which also determines if your activity violates the wash-sale rule.

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