Rules of the Wash-SaleThe 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.
The Repercussions of a Wash-SaleWhile 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 ImplicationsIf 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.
Deferred, Not Completely EliminatedUnder 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.
Savvy SubstitutesWhen 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.