Know The Wash Sale Rule When Selling Those Losers
The year end is a popular time to sell investment losers for tax purposes. But this strategy can fail from not knowing the wash sale rules.
The tax strategy for year end selling is pretty simple. By selling investments at a loss, you can offset capital gains or even income. Potentially lowering your taxes for the year. The IRS has rules limiting what you can do with those funds after the investment is sold. Which is not something you want to overlook. Especially when tax filing time rolls around and you owe more because of a mistake.
The Wash Sale Rule
The first thing that pops into someone’s head when selling a stock (or any investment) for a tax loss is to turn around and buy it back. Getting it at a lower price is potentially a great deal. Ingenious, right? It’ll work but you’d lose out on the tax deduction. The IRS already thought of this and really wants those tax dollars. So it put in some stipulations on what qualifies for tax deductions. Known as the wash sale rule.
A wash sale occurs when you sell a stock (or other security) at a loss, and within 30 days before or after the sale you:
- Buy substantially identical stock or securities
- Acquire substantially identical stock or securities in a fully taxable trade, or
- Acquire a contract or option to buy substantially identical stock or securities
“Substantially Identical”
The IRS does us no favors with the vagueness of the wash sale rule. By using “substantially identical” it leaves a lot of wiggle room for the IRS to approve or deny a deduction. So it’s always good to err on the side of caution when putting any money back to work.
Its safe to say that the obvious rule breaker is to not buy the same stock that was sold or any contracts for that stock inside of the 30 day period. If you really like the stock, an alternative is to find a similar stock in the same sector. So if you sold stock in Ford you could turn around and buy shares of GM. This avoids the wash sale rule and gives you a similar stock for your portfolio. Of course, buying a stock outside the sector entirely would also be safe.
Things get a little tricky when looking at ETFs and mutual funds though. Take an index fund for example. I’d be weary selling one S&P 500 index fund for a loss only to turn around and buy another S&P 500 fund from a different fund family. The better choice would be an index fund entirely unrelated to the S&P 500, like a Russell 2000 fund or a sector specific fund.
It’s always best to be safe when it comes to these investment decisions and the wash sale rule when you file your taxes. As always, if you’re just not sure if a stock (or other security) falls under the “substantially identical” label, talk to a tax professional. Or just wait to buy anything until after 31 days.
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I think the best way to be safe is to change 4 things:
1) buy a new investment type (i.e.ETF, CEF, Mutual Fund),
2) in a new account (i.e. sell a mutual fund in your mutual fund only account and the buy in a brokerage account)
3) At different broker (sell in Vanguard, buy in E-trade)
4) With a different exposure, as you had mentioned (i.e. sell the S&P 500 index mutual fund and buy the Extended U.S. stock market Index)
Even better would be if you sold in your taxable brokerage and then bought in your IRA…. I think if you do all these things you will avoid any wash sale issues.
Some good points. Though the IRS should still know about selling and buying across multiple accounts. Especially with the new cost basis reporting requirements on the brokers side going forward. It’s always best to be safe with the “substantially identical” statement.
Your point regarding selling from a brokerage account and buying in an IRA is an excellent way to avoid the wash sale rule, still own a security, and get the tax deduction.
Excellent advice. You do not want to mess with the IRS.
Yeah – the rule is completely appropriate too, as long as losses are an allowed deduction. Imagine if there was no wash sale rule? Every down year would have ridiculous volatility near the end of the December as everyone re-bought all of the stocks they lost money on, haha.
I’m not as careful as Neo, but I do at least make sure my funds aren’t tracking the same indices.
Good to know – I always play it safe with Uncle Sam.
Personally, I’d just rather leave my indexed investments alone. It’s not worth the increased hassle with the IRS and the trading fees for me. Of course my portfolio is still pretty modest, so this obviously makes a difference as well.
Sometimes it’s better to just leave things alone. But the tax savings is still a big draw. Just have to weigh whats more important, a short term tax deduction vs. long term goal. I don’t have the numbers in front of me but it would be interesting to find out the impact of missing a month like December or January long term.
Unless you trade for a living it usually ends up costing you in lost gains and fees. Dollar cost average, diversify among asset classes, and re-balance quarterly and you will be fine.
While I agree with you, one disadvantage of rebalancing usually involves sell a portion of a better performing asset. Which adds to the yearly tax burden every time a rebalance is done. Selling loser positions offers a way to offset those gains and added tax. One can even offset income by just selling losses and save on taxes that way. Taking a $1,000 loss at a 25% tax rate saves $250 in taxes for the year. Sounds good to me, especially if the commission is only $10 a trade.
Terrific advice! If you really want to buy back in perhaps you can switch to a fund that is heavily weighted in the stock you just dumped.
Every tax year I read about the wash rule and I am so curious how many people actually do it besides us PF Nerds lol