Wash Sale Rule: Protecting Investors from Tax Loss Harvesting

The Wash Sale Rule was instituted as part of the IRS Code 550 to prevent investors from taking a tax loss on securities they still hold.

Here’s what that means.

Imagine this scenario.

Typically, when you buy a stock at a particular price, the expectation is that the stock will go up and eventually, you will make money off those gains.

As imperfect as the world is however, there are times when the stock begins to go in the wrong direction.

It is at this point that some investors are tempted to sell off that particular stock.

If this particular stock is on a real nosedive, it is possible for you to sell this stock, wait a few days when it is even lower and then buy that stock back again (that is, if you have some confidence that it will turn up the right way again.)

If you buy back that stock or buy a stock that is “substantially similar” within 30 days of making a loss of the stock you just sold, it is considered a “wash sale”.

Once this happens, the IRS will not allow you to claim a loss on the original stock you sold when you file your Schedule D forms.

The government wants to make sure that people are not claiming tax losses for stock they technically own.

A wash sale also occurs when you buy a substantially similar stock 30 days before you sell and make a loss on a stock.

To quote the exact language on the United States Securities Exchange Commission (SEC) website, a wash sale occurs “when you sell or trade securities at a loss and within 30 days before or after the sale you:

• Buy substantially identical securities,

• Acquire substantially identical securities in a fully taxable trade, or

• Acquire a contract or option to buy substantially identical securities.

How The Wash Sale Rule Works

If you bought 100 shares of stock A at $1,000 on May 10 and then realized the stock was going down and so sold those 100 shares for $700 on June 1 - this would mean you made a loss of $300 on the sale. 

If you don’t take any action after this, you are fine. You can claim a loss on your taxes come tax season.

However, if you went ahead and bought back that stock on June 25 (less than 30 days after you made the loss), you will not be able to claim that loss on your taxes.

While the SEC and the IRS are not completely clear on what a “substantially similar stock” means exactly, to be on the safe side, it is important that if stock A was a stock in the pharmaceutical industry, you don’t purchase an identical stock from an identical pharmaceutical company (stock B) within that 30-day window.

Similarly, if you purchased stock B on June 1 and then sold A on June 15th (in this case, stock B is purchased before stock A is sold but within the 30-day window) and made a loss, you cannot claim the loss when you go to file a Schedule D.

What Happens To Your Loss?

The good news is that, in a wash sale, even though you cannot claim the loss immediately, it is not an “absolute loss”.

The amount you lost will actually be added to the basis of the replacement stock or security.

And so in our hypothetical situation above, the investor can claim a loss on the replacement stock transaction.

Wash Sale Rule and Cryptocurrency

The Wash Sale rule currently doesn't apply to cryptocurrency transactions, although pending legislation is seeking to change that. As such, you can buy and sell the exact same crypto (say Bitcoin) and take advantage of short term price movements.

What This Means For You As An Investor

• It is important for you to track your trades closely to ensure you avoid inadvertent wash sales that could cost you big money

• If you do sell a stock and would like to repurchase a similar stock OR you purchase a stock and would like to sell off a similar stock, it might be necessary for you to wait until you are out of the 61-day window to avoid a wash sale

• Even if you sell and buy stock in separate investment accounts, a wash sale can occur. A wash sale is attributed to the investor not the accounts in which they occurred

Final Thoughts

Paying attention to rules like the Wash Sale Rule will save you hundreds or even thousands of dollars on your investments that you should not be losing in the first place.

We recommend talking to your broker and tax professional to gain clarity on the rules of trading stocks.

Or if you are up to it, you can read the IRS Publication 550 to gain an even in-depth understanding.

Have you ever heard of the Wash Sale Rule or been able to take advantage of it? Your thoughts and comments are welcome.