When you sell an investment for a loss in a taxable brokerage account, there can be
a silver lining: You may be able to claim that loss on your taxes.
But there are limits to this strategy.
One of these is the wash sale rule.
This can be one of the more confusing rules when it comes to reporting your capital gains
and losses, so let's break it down.
In a nutshell, if you sell a security at a loss, and within 30 days before or after that
sale, buy the same or substantially identical security, the loss is disallowed and cannot
be claimed on your taxes.
The wash sale rule was designed to discourage investors from selling securities at a loss
simply to claim a tax benefit before turning around and buying back the same stock.
To help illustrate this rule, let's look at a few examples.
On Monday, an investor purchased a share of XYZ stock for $100.
Tuesday, the stock fell to $90, and the investor sold it for a $10 loss.
Then, on Wednesday, he repurchased the stock at $92.
This is a wash sale, which means the $10 loss is not deductible.
But that loss can be used another way to potentially reduce taxes in the future.
Suppose our investor, who rebought those shares at $92, sells them again a few months later
at $110.
This would typically count as a gain of $18.
But the previous loss of $10 can be added to the cost basis, or starting point, of this
trade.
That means the adjusted cost basis is $102, leading to a gain of $8 instead of $18 as
far as taxes are concerned.
But what if our investor bought fewer shares than he sold at a loss?
Say this investor purchased 20 shares of XYZ stock at $100 per share.
He sold all 20 shares at $90 for a loss.
Fifteen days after the sale, he repurchased 10 shares of XYZ stock at $92 per share.
The investor can claim the loss for the 10 shares he did not repurchase, but the loss
on the other 10 new shares that were repurchased is disallowed and is added to the cost basis
of the new shares.
The wash sale rule applies to shares that are bought before a wash sale too.
Let's say an investor bought 10 shares of XYZ at $100, then purchased another 10 shares
a month later at $110.
A week after that, he sold the original 10 shares at $90.
Because he purchased 10 new shares of XYZ within the wash sale window, which includes
30 days prior to the sale, he would not be able to claim the loss.
Instead, the cost basis of the shares purchased a week ago would be adjusted to $120, and
the holding period would be adjusted as well.
These are just three examples, but wash sales can be more complex, particularly when it
comes to identifying what qualifies as a substantially identical security.
In a nutshell "substantially identical" means the same security or stock, but it can be
more complex than that.
For example, options on a stock you just sold are considered to be substantially identical
securities.
Things can get even more confusing when it comes to selling index funds, like ETFs.
To avoid the wash sale rule on ETFs, it's generally recommended to repurchase an investment
in a different index.
For example, you could sell your S&P 500® ETF and purchase a Russell 2000® ETF.
Ultimately, reporting wash sales and identifying what counts as a substantially identical security
is each investor's responsibility.
Unfortunately, brokers can't identify most wash sales for you because they're generally
only able to see wash sales in a single account and for identical investments.
It's up to you to consider all other possible wash sales across all your investment accounts,
even those accounts at different firms.
The wash sale rule also requires you to look at transactions within your spouse's accounts
and your IRAs.
If you have any questions about wash sale reporting, it's a good idea to talk to a tax
professional or a financial advisor.
But remember, it's up to you to report wash sales correctly.