A Primer on Wash Sales
The wash-sale rule was designed to discourage people from selling securities at a loss simply to claim a tax benefit.
A wash sale occurs when you sell a security at a loss and then purchase that same security or “substantially identical” securities within 30 days (before or after the sale date).
If you end up being affected by the wash-sale rule, your loss will be disallowed and added to the cost basis of the securities you repurchased.
The wash-sale rule was designed to prevent investors from selling a security at a loss so they can claim tax benefits, only to turn around and immediately buy the same security again. Even investors who have no intention of breaking this rule can get tripped up by it if they use an automatic investment strategy, such as reinvesting dividends, potentially costing themselves some tax benefits in the process.
Here we'll take a closer look at the wash-sale rule and answer some common questions about it.
Q: I want to sell a stock to take a tax loss, but I plan to buy it again because I want it in my portfolio. What are the tax implications?
If you want to sell a security at a loss and buy the same or a substantially identical security within 30 calendar days before or after the sale, the wash-sale rule will kick in.
In such cases you won’t be able to take a loss for that security on your current-year tax return. Instead, you will have to add the loss to the cost basis of the replacement security. In addition, the holding period of the original security gets tacked onto to the holding period of the replacement security.
Here’s an example of how this might work:
Let’s say you buy 100 shares of XYZ stock for $10 per share ($1,000 of stock). One year later, the stock starts dropping, so you sell your 100 shares for $8 per share—a $200 loss. Three weeks later, XYZ is trading at $6 per share and you decide that price is too good to pass up, so you repurchase the 100 shares for $600. This triggers a wash sale.
As a result, the $200 loss is disallowed as a deduction on your current-year tax return and added to the cost basis of the repurchased stock. That bumps the cost basis of your $600 of replacement stock up to $800, so if you later sell that stock for $1,000, your taxable gains will be $200 instead of $400. And because you previously held XYZ for a year, it will automatically be treated as a long-term capital gain, even if you sell it after just a few months.
A few other things to note: A higher cost basis decreases the size of any future gains realized from the sale of the replacement security, thereby lowering your future tax obligation. If you sell the investment at a loss, the higher cost basis would actually increase the size of the loss for which you could claim a deduction.
And one of the potential upsides of an extended holding period is that it would lower your tax obligation if you sold the replacement security after less than a year. (Normally, short-term capital gains from investments held for less than a year are taxed at the higher regular income tax rate, while longer-term capital gains are taxed at the lower capital gains rate).
Q: What was Congress trying to accomplish with the wash-sale rule?
Basically, the goal is to prevent people from selling securities for no other reason than to generate losses that could be used to reduce their taxable income. Before the law was in place, investors could sell a losing stock and then buy it again a minute later, effectively locking in a loss to reduce their taxes.
Q: What if I wanted to sell a security to take a loss, but didn’t want to be out of the market for an entire month just to avoid the wash sales rule? What could I do?
You could sell the security at a loss and the use the proceeds from that sale to purchase a similar —but not substantially identical—security that suits your asset allocation and long-term investment plan.
Unfortunately, the government has not provided a straightforward definition of what it considers “substantially identical.” Investors will have to use their best judgment to avoid the wash-sale rules.
Here's an example of how the process would work. Let’s say you own an exchange-traded fund (ETF) that is closely correlated to the S&P 500® Index and you end up selling that ETF at a loss. You could then use the proceeds from that sale to purchase a different ETF (or multiple ETFs) with similar but not identical assets, such as an ETF that tracks the Russell 1000® Index. By doing this you are able to take a loss on your current year tax return and still remain in the market with about the same asset allocation in your portfolio.
The process of taking losses and finding other investments that meet your needs isn’t always easy. To successfully harvest a tax loss, you have to monitor your asset allocations, watch out for wash sales, and make sure that the replacement assets you buy aren’t substantially identical.
Q: If I purchased and sold shares of a stock at a loss in one of my Schwab accounts and then repurchased them in another Schwab account, would I still trigger the wash-sale rule?
Yes, wash-sale rules apply across all of your accounts, including those outside Schwab. In addition, wash-sale rules also apply to transactions in your spouse’s accounts. IRS regulations require only that Schwab track and report wash sales on the same CUSIP number (a unique nine-character identifier for a security) within the same account. Ultimately, each individual is responsible for tracking sales in their accounts (and their spouse's accounts) to ensure they don’t have a wash sale.
Q: Do the wash sale rules apply to ETFs, mutual funds and options?
Yes, if the security has a CUSIP number, then it's subject to wash-sale rules. In addition, selling a stock at a loss and then buying an option on that same stock will trigger the wash-sale rule.
ETFs and mutual funds present investors a different set of challenges. Switching from one ETF to an identical ETF offered by another company could trigger a wash-sale. There are ways around this problem. For instance, an investor holding an ETF indexed to the S&P 500 at a loss might consider switching to an ETF or mutual fund that is indexed to a different set of securities, such as the Russell 1000 or Dow Jones Industrial Average.
Q: What would happen if I sold a security at a loss in a taxable account and then immediately repurchased it in a retirement account, such as an IRA?
The IRS has ruled (Rev. Rul. 2008-5) that when an individual sells a security at a loss and then repurchases that security in their (or their spouses’) IRA within 30 days before or after the sale, that loss will be subject to the wash-sale rules.
Q: Could I sell a security at a loss on Dec. 15, in order to squeeze it into the current tax year, and then repurchase the security on Jan. 4 without triggering a wash sale?
No, the wash-sale rules are not confined to the calendar year. In this situation and your loss would be disallowed if you reacquired the security within 30 days.
Make sure that you’re considering the potential tax implications of your investments.
Read Publication 550, Investment Income and Expenses for more information.
Talk to a financial professional. Call Schwab at 800-355-2162, visit a branch, or find a consultant.
The information provided is for general informational purposes only. Nothing in this article should be considered as an individualized recommendation or personalized investment or tax advice. The investment and tax strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment or tax strategy for his or her own particular situation before making any decision.
All expressions of opinion are subject to change without notice in reaction to shifting market conditions. Examples provided are for illustrative purposes only and are not representative of intended results that a client should expect to achieve.
This information is not intended to be a substitute for specific individualized tax, legal or investment planning advice. Where specific advice is necessary or appropriate, Schwab recommends consultation with a qualified tax advisor, CPA, financial planner or investment manager.
Examples provided are for illustrative (or informational) purposes only and not intended to be reflective of results you can expect to achieve.
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