If you’ve been investing for any period of time, you’ve likely run across the term Wash Sale – do you know what it means? And what are the IRS rules regarding Wash Sales?
In a nutshell, a wash sale occurs when you sell a security (stock, bond, or mutual fund, for example) at a loss, either followed by or preceded by a purchase of substantially the same security within 30 days of the sale. The IRS disallows the recognition of the loss in such cases – where normally, if the sale was not considered a wash sale, you would be allowed to utilize the capital loss to offset other capital losses and possibly offset ordinary income, depending upon the circumstances.
The Details
If you sell, at a loss, a security of any sort that would be treated as a capital item, the loss would be disallowed for tax purposes if you purchased substantially the same security within 30 days before or after the sale:
- In a taxable account or a deferred account (all accounts under your household are counted together, that is, yours, your spouse’s, and any corporation you control)
- As options or futures contracts
Prior to Revenue Ruling 2008-5, you used to be able to effectively purchase a new position in your IRA or Roth IRA within the 30 day period and it would not engage the wash rule, but this has been disallowed now.
So what makes up a substantially identical security?
In the IRS’ own words:
In determining whether stock or securities are substantially identical, you must consider all the facts and circumstances in your particular case. Ordinarily, stocks or securities of one corporation are not considered substantially identical to stocks or securities of another corporation. However, they may be substantially identical in some cases. For example, in a reorganization, the stocks and securities of the predecessor and successor corporations may be substantially identical.
Similarly, bonds or preferred stock of a corporation are not ordinarily considered substantially identical to the common stock of the same corporation. However, where the bonds or preferred stock are convertible into common stock of the same corporation, the relative values, price changes, and other circumstances may make these bonds or preferred stock and the common stock substantially identical. For example, preferred stock is substantially identical to the common stock if the preferred stock:
- Is convertible into common stock,
- Has the same voting rights as the common stock,
- Is subject to the same dividend restrictions,
- Trades at prices that do not vary significantly from the conversion ratio, and
- Is unrestricted as to convertibility.
The above is quoted directly from IRS Publication 550
The question comes up all the time – I always say as a rule of thumb that if you have to question whether your choice of a replacement is substantially identical or not, then it’s not worth it to have to argue the point with the IRS when you’re audited. It’s only 30 days, after all.
Examples
So, instead of allowing the loss, the IRS gives you the ability to increase the basis of the security that you purchased, by the amount of loss that you were disallowed.
Example 1: You own 100 shares of stock that you purchased last year for $1,000. You sell those shares for $750, and within 30 days, you purchase another 100 shares for $800. You have a disallowed loss of $250, which will be added to the basis of your current holding, making the basis now $1,050 ($800 plus $250).
Example 2: You purchase 100 shares of stock for $1,000, and then sell them for $750 within 30 days. Your loss is disallowed. In this case, since you don’t own the stock any more, the loss is just gone, unless you repurchase the position within 30 days.
Example 3: You own 100 shares of stock that you purchased last year for $1,000. You sell all 100 of those shares for $500, and within 30 days you purchase 50 shares again for $200. These 50 shares will have a basis of $450 due to the disallowed loss of $250. You would still have an allowed loss of $250 for the activity unless you repurchased additional shares within 30 days.
It can get really complicated if you have multiple purchases and sales and overlapping 30 day periods, so if you have a particular situation that you’d like to review, please let me know. Other complicating factors include the use of short sales, options, and futures contracts.
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