What’s the wash-sale rule? Many investors are confused by the wash-sale rule and how it works. For those unfamiliar with the IRS wash-sale rule, also known as IRC Section 1091, it’s a tax law that says you can’t deduct any losses from investment activities on your taxes if you buy back any of those same investments within 30 days of the sale.
That sounds like some complicated nonsense, right? I know this is a bit complex to understand, but once you get the hang of it, it will make sense to you, and you can make an informed investment decision to save money on tax.
The Wash-sale rule: The introduction
The Wash-sale rule prevents you as an investor from recognizing a loss when you sell substantially identical security at an unendurable price. That means if you sell a security at a loss, you cannot claim a tax deduction on the loss that occurred if you buy the same stock/security within 30 days.
Wash sales are usually illegal and are considered an attempt to avoid taxes or to circumvent regulatory measures. They can also use them to cover up trading activity that is not in the best interest of the person or organization involved.
Does it still sound gibberish? Read for more information about The Wash-Sale Rule.
When does the Wash-sale rule apply? | How does the wash-sale rule work?
The Wash-Sale rule applies to Stocks, Bonds, Mutual Funds, ETFs and Options.
The wash sale rule applies when you sell a security at a loss and buy a “substantially identical” security within 30 days. However, it does not apply if you buy a security that is not substantially similar to the one you have sold. The IRS defines a “substantially similar” security as “equivalent to or a substitute for the one sold.”
This rule prevents you from buying similar security and using the loss to offset the gain you would otherwise have recognized.
For example, let’s say you own 100 shares of ABC stock, valued at $10 per share. You decide to sell the ABC stock and incur a loss of $1,000. Now, let’s say that you buy 100 shares of XYZ in two weeks, which also has a market value of $10 per share. You will not be able to recognize the loss incurred when you sold the ABC because of the wash sale rule. The reason is that you are trading one stock for another.
The relationship between the two securities is the key to determining whether a purchase is a wash sale. The price, maturity and other terms of the stock or securities are irrelevant to the wash sale rule. For example, if you sell a security at a loss and then buy different security with the same risk and potential profit, you will not be subject to the wash sale rule.
Protect yourself from the Wash Sale Rule When Harvesting Tax Losses
A loss on your investments might not be as beneficial as you think, especially if you hope to use it to offset capital gains or reduce your taxable income. That might be a downer for those who follow a tax-loss harvesting strategy.
Avoid violating a wash-sale rule when harvesting tax losses. The wash sale rule prohibits investors from taking a tax deduction on a security sold at a loss if they repurchase the same security within 30 days of the sale date. To avoid this, use mutual or exchange-traded funds instead of individual stocks so you’re not constantly violating the rule.
You can repurchase Mutual funds right away without running afoul of the law. However, remember there are two types of wash sales: short-term and long-term. Short-term wash sales occur when an investor sells a stock for a loss and buys more than 30 days before or after the date of sale.
What to avoid when selling your stocks for a tax loss
It would help if you did not sell investments in a taxable account. The IRS has the right to reclassify the sale as a short-term or long-term capital loss if it feels that you have tried to avoid paying taxes by selling an investment, not a retirement account.
If you trigger a wash sale, it will limit your losses to only the amount of the difference between what you sold and what you bought. So let’s say you buy 100 shares of XYZ Company for $1,000 each ($100,000), then sell those shares at $750 each ($75,000).
A tax professional might tell you that this would create a wash sale, and all your losses would be capped at $25,000 because the share price decreased by more than 50%. Let’s assume that XYZ company started trending the following year upward, and its shares went up to $1,500.
Strategies to Benefit from the Wash Sale Rule
Tax-loss harvesting is a strategy that allows you to offset your capital gains with your tax losses. This strategy is used when an investor sells a stock at a loss to take advantage of the reduced cost basis.
The wash sale rule is a set of rules related to this tax strategy. If you buy and sell stocks within 30 days, the IRS deems it a wash sale and does not allow you to use the loss for tax purposes.
However, there are two ways in which you can still take advantage of the wash sale rule. In doing so, the investor may incur a capital gains tax on the sale but will be able to write off the capital losses from other investments in the same year, thereby saving money on taxes.
First, any loss from the purchase will be allowed if you buy back the same security at least 31 days before or after your initial sale (cost basis). Second, if you own shares of mutual funds or ETFs, any investments inside those funds will be considered separate and have different cost bases.
You can sell these investments anytime without affecting one another’s cost basis (provided they’re more than 31 days apart).
Another strategy that can work with the wash sale rule is a synthetic replacement, which involves using one security position as collateral for another.
Let’s understand this with an example. If you bought 1 share of Company A at $10 per share and sold 1 share of Company A for $5 per share, you would have realized a $5 per share loss. Suppose you purchased the security of Company A with funds borrowed from Company B (i.e., Company A was financed by debt).
In that case, you could sell 1 share of Company B to repay the debt owed to Company B while still realizing your loss in full on your purchase of shares in Company A. That way, you are selling 1 share of Company A for $5 ($10 minus the loss) and selling 1 share of Company B for $5 ($5 minus the gain). Since your total profit or loss will remain at $0, there is no violation of IRS wash-sale rules.
Crypto Wash-Sale Rule: Does it apply to Crypto Trading? | Wash-Sale vs Crypto
The wash-sale rule does not explicitly apply to crypto trading. However, the IRS has indicated that it may apply the wash-sale rule to crypto transactions if it determines that the transactions are part of a scheme to avoid paying taxes on gains. For example, if an investor sells a crypto asset for a loss and immediately buys a similar crypto asset, the IRS could treat the transaction as a wash sale and disallow the loss.
Currently, the Wash-Sale rule does not apply to crypto trading. However, this could change in the future, so it’s important to stay current on any changes.
Investors should know that the wash-sale rule may apply to their crypto trading activities. They should consult a tax advisor to determine whether the rule applies in specific circumstances.
You can find more insights on Wash Sale Rule in the video below.
Conclusion
IRS (Internal Revenue Service) has imposed the wash sale rule to prevent you from recognizing a loss on a favourable price in the future when you sell the same security at an unendurable price. To avoid this, it’s crucial that you not sell or buy back the same security within a 30-day window.
Frequently Asked Questions (FAQs)
The Wash-Sale rule applies to Day trading because if you sell a security at a loss and then buy the same or similar security within 30 days, the loss is not recognized for tax purposes. This is because the IRS considers this to be a “wash sale.” To avoid the wash sale rule, you must wait at least 31 days before buying the same or substantially similar security.
There are a few different things that can cause a wash sale. One is if you sell a security at a loss and then buy the same security within 30 days. Another is if you sell a security and then buy a substantially similar security within 30 days. Finally, if you sell a security and your spouse or a corporation you control buys the same security within 30 days, that can also trigger a wash sale.
There is no penalty for a wash sale. If you sell or trade securities at a loss and buy “substantially identical” securities within 30 days before or after the sale, you generally cannot deduct the loss as per the Wash Sale rule. If you have a wash sale, you must add the disallowed loss to the cost of the new stock or mutual fund. This adjusts your cost basis. When you sell the new stock or mutual fund, your gain or loss will be based on this adjusted cost basis.
Simply you cannot. Even if you buy more assets of the same security and sell them 30 days before or later and claim a loss on your tax bill. IRS does not allow this sort of activity.
Claiming a substantial deduction to save taxes may catch IRS’s eyes and trigger an audit.
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