What Is The Wash Sale Rule?

Wash Sale RuleThe tax code is constantly changing. Sometimes you can get a leg up on next year’s tax changes by taking advantage of any current favorable tax code.

In this case, it involves selling losing investments for a tax deduction. The goal, of course, is to lower your tax bill at the end of the year. Right or wrong, this strategy can fail if you don’t know the wash sale rule.

The Wash Sale Rule

The concept is fairly simple. You own a stock (bond or fund) that drops in value. The tax code may allow you to deduct that loss, but only if you sell the stock. Which is the problem, because you really want to keep it. So you come up with this diabolical scheme to sell the stock for the tax deduction and then buy it back.

It’s pure genius! Except the IRS knew all about your plan before you thought of it. So it added rules on what qualifies as a tax deduction and what doesn’t.

A wash sale is when you sell a stock (bond or fund) 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, or
  • Acquire substantially identical stock for your individual retirement account (IRA) or Roth IRA

It doesn’t end there either. If you sell stock and your spouse buys substantially identical stock you get a wash sale too. The IRS has a long list of rules for every situation.

That’s Tax Speak For Similar

The IRS does us no favors with the vagueness of the wash sale rule. By using “substantially identical” it leaves some 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.

It’s 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.

A Disallowed Loss

The wash sale rule is designed to prevent you from claiming a tax loss while still trying to maintain ownership in a stock. That’s why a 30 day window is used.

A sale and then repurchase of the same stock (bond, ETF, or mutual fund) inside the 30 window before or after the sale, is considered a disallowed loss. You can’t claim the loss of the sale. The disallowed loss is added to the cost basis of the repurchased stock. And the holding period of the repurchased stock includes the holding period of the sold stock.  Confused yet?

For example, you own 100 shares of McDonald’s (MCD) bought at $100. The year-end rolls around and the stock price drops. So Dec 3, you sell the 100 MCD shares at $80 for $8,000 ($10,000 – $8,000 = $2,000 loss). But on Dec. 28, you buy 100 MCD shares for $8200.

These repurchased shares fall inside the 30 day window so the wash sale rule applies. You won’t be able to claim a $2,000 loss from the original sale. Instead it becomes a disallowed loss and is added to the cost basis of your repurchased shares. Meaning you add the $2,000 loss to the 100 MCD shares you repurchased for $8,200 giving you a new cost basis of $10,200.

The good news is you still carry a loss in those shares. Those shares can be sold later and claimed as a loss. But only if you don’t make the same mistake of repurchasing shares inside the 30 day sale window.

Just Stick To Your Plan

Taxes are inevitable. Trying to finagle your portfolio every year just to lower your taxes puts your success at risk. You already know when to sell a stock. That should be your focus. If you happen to sell an investment for a loss and can take a deduction, great. A successful long-term investment strategy shouldn’t change too often anyways.

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