The American tax code is one of the most complex and comprehensive set of laws there is and can be quite difficult to understand and navigate. Due to the complexities, many investors have questions regarding how the wash sale rule works and what it is. Here are two important points to highlight about this rule that we will explain below:
- The Wash Sale Rule does NOT apply to profits or gains of a sale. Only losses.
- Though you may incur losses, that loss is allowed to be applied to the future purchase of the shares to bring up your cost basis, regardless of the 30 day window.
So let’s first ensure you understand this rule. According to the internal revenue service (IRS), a wash sale can happen only when an investor sells an investment for a loss, and then buys or replaces it with the same or a “substantially identical” investment 30 days before or after the sale.
The wash sale rule was first implemented to prevent taxpayers from deducting a capital loss on sales against capital gains. (note: this does not apply if you have set yourself or your business up for tax filing as a “trader”. (You an learn more on that here as IRS requires ~300 trades a year to qualify, though for latest on that, click here.).
So many investors ask:
Question: If I sold a particular stock for a gain and bought the same stock but lower price within 30 days, would there be any issue?
Answer: There is no issue. The wash sale rule does not apply to gains. Uncle Sam is happy to collect its taxes on your gains.
Of course, it you don’t protect profits properly, then the above scenario becomes a wash (pun intended). The key to winning in the stock market is to learn how to let winners run. That’s why our Smart (R) Trailing stop becomes valuable. It knows how to adjust intelligently vs. some dumb random % number for what the brokers offer as a trailing stop setting. You can learn more on Why SmartStops is better. Or just take advance of our Instant Risk Alerts to know when to take action .
Question: But what happens if I sell and take a loss?
Well first congratulate yourself, that you are mastering “minimizing losses” as that’s the other part of the stock investing paradigm. Learning to let winners run while cutting losses. You can have a 50% win rate and still come out way head by mastering the discipline to reducing your losses.
Answer: If you decide to purchase the same financial asset within 30 days after your sale, then the wash sale rule applies. But that loss doesn’t vanish so read on.
For example, if an investor purchased 100 shares of XYZ Corp. on December 1, 2018 for $2,000. On April 1, 2019, and sold the shares for $1,200 thus incurring a short term loss of $800. If you went and repurchased those same shares on April 27, 2019, your $800 loss is disallowed. BUT… all is not lost….
The good news is that your “disallowed loss” doesn’t just go up in smoke. Instead, it gets added to the cost basis of the replacement purchase even if that replacement purchase is within the 30 day window. And when you sell that replacement security, the disallowed loss effectively reduces your gains or can be added to that loss on that transaction (if not again replaced).
So in the example above, you get to add in the $800 initial loss to the cost basis of the repurchased shares.
Moreover, the holding period of the wash-sale security is added to the holding period of the replacement security which means you might be closer to a long-term (15%) capital gain vs. a short-term and higher one depending upon when you purchased initially and then replaced
When an investor files for taxes they will report the wash sale on Part I of Form 8949, which will feed into Schedule D because it was a short-term transaction.
Question: Are there any ways around the Wash Sale Rule?
Answer: There are ways you could take the initial loss. Instead of buying the same company’s shares back, you could buy an ETF or mutual fund instead. Though this strategy doesn’t exactly replicate the initial position, you could then sell that after the 30 dayshas passed. To see what ETFs are holding the stock you are interested in, a free lookup by symbol resource is available at ETFChannel.com.
There can be many challenges in correctly accounting for your wash sales in a given year. It would be best to monitor all of your accounts, trades, and transfers. If you are not very familiar with the tax codes and laws, it would be best to be hire a CPA familiar with the rules.
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