The tax law doesn’t want you to be able to churn your holdings solely for tax advantage without really changing your economic position. To this end, there is a restriction in the tax law calledthe wash sale rule”. This rule prevents you from recognizing a loss on the sale of a security if you acquire a substantially identical one within 30 days before or after the date of sale. This post provides information and light tax law guidance: wash sales rules through the following sections: substantially identical securities,  basis adjustment,  how to take a tax loss while avoiding the wash sale rule.

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Back to the statement at the paraphrase that the wash sale rules, if you sell 10 shares of Y Corp. at a loss on May 1 and two weeks later on May 15 you buy 10 shares of Y Corp., you cannot deduct the loss on the May 1 sale. The wash sale rule has no applicability to gains. You can sell for profit as often as you want (each gain must be reported). However, the wash sale rule applies to short sales. If you incur a loss when you close a short sale within 30 days before or after another similar short sale, the loss cannot be recognized.

 

Wash Sale Rule – Substantially Identical Securities

The wash sale rule applies to stocks, bonds, and mutual fund shares that are the same or substantially identical. Selling stock in Hewlett-Packard (HP) at a loss and buying shares in Apple Inc. within the wash sale period are not subject to the wash sale rule. Although HP and Apple are both technology companies and each sells computers, they are not viewed as substantially identical.

Similarly, selling shares in a Vanguard S&P mutual fund at a loss and buying shares in a Fidelity S&P mutual fund within the wash sale period does not fall within the wash sale rule, because these funds have different fees and other differences that keep them from being substantially identical. Shares in different funds within the same mutual fund family are, of course, different securities and are not subject to the wash sale rules. If you sell shares from a Fidelity stock fund at a loss and buy shares in a Fidelity bond fund within the wash sale period, the loss can be recognized.

Bonds are not viewed as substantially identical, even if they are from the same issuer, if there is any difference in interest rates. However, differences in maturity or interest payment dates do not create significant differences, and bonds bearing these small differences will be treated as substantially identical securities subject to the wash sale rules.

The wash sale rule applies to any option you buy to acquire a substantially identical security within the wash sale period. The wash sale rule cannot be avoided by having a controlled person acquire a substantially identical security within the wash sale period. A controlled person for this purpose is a spouse or a corporation you control.

 

Basis Adjustment Of The Wash Sale Rule

The loss from a wash sale generally is not lost forever; it is preserved in the basis of the newly acquired security. Thus, the fact that you really suffered an economic loss when you made the sale is taken into account.

Tips: You add the disallowed loss to the basis of the new security, so that when the newly acquired security is sold, the deferred loss will be recognized [or the gain will be minimized to the extent of the deferred loss].

 

Example: You own 100 shares of X Inc. that cost you $1,000. You sell these shares for $800 and, within 30 days from the sale, you buy 100 shares of the same stock for $850. Because you bought substantially identical stock, you cannot deduct your loss of $200 on the sale. However, the disallowed loss of $200 is added to the cost of the new stock, $850, to obtain your basis in the new stock, which is $1,050. If you later sell the new stock for $1,050, you have no recognized tax gain even though the stock cost you only $850.

The holding period of the newly acquired security includes the holding period of the old security. However, if there is time between the date you sold the old security and the date you purchased a new security, don’t add the intervening time to your holding period; include only the actual holding period of the old security as part of the holding period for the newly acquired security.

 

Rule Applies to All Accounts

In the past, some tax experts believed that you could get around the wash sale rule by selling a security within a taxable account and then acquiring the same security during the wash sale period in a tax-deferred account, such as an IRA or a Roth IRA. However, the IRS has ruled that the wash sale rule applies when you sell in your taxable account and then cause your tax-deferred account (IRA) to acquire a substantially identical security during the wash sale period. Even worse, the basis of the IRA cannot be increased by the loss that is disallowed under the wash sale rule; it is lost forever.

 

How To Take A Tax Loss While Avoiding The Wash Sale Rule?

If you want to take a tax loss while avoiding the wash sale rule, there are various steps you can take if you want to preserve your investment position in the same security:

  • Wait out the wash sale period before reacquiring the same security.
  • Use a technique called doubling up. You buy the same number of shares in the company you’re currently holding and then, after the wash sale period has expired, sell off the old shares, leaving you with the same number of new shares in the same stock.
  • Play an industry rather than a company. If you believe in a particular industry, you can sell your losing shares and immediately buy shares in a competing company without triggering the wash sale rule. Of course, the competing companies may be worlds apart because no two companies are identical (though both may benefit or be hurt by conditions within their industry).
  • Buy bonds that are similar but have slightly different interest rates. If interest rates are different, the bonds are not substantially identical.
  • Acquire a smaller number of shares in the same security during the wash sale period. You’ll be able to recognize a portion of the loss in this case. For example, if you sell 100 shares and within the wash sale period you buy 50 shares of the same corporation, only half of your loss is disallowed; the other half can be recognized.

 

The wash sale rule can be a positive rather than a penalty. You can use the wash sale rule to your advantage in timing year-end transactions. Say, for example, that you’re in negotiations to sell an asset at the end of the year for a profit but aren’t sure when the deal will close. You can sell losing stock late in December to create a deductible loss. If the profitable deal closes in December, then you’ve created an offset to your gain. If the deal doesn’t close until January, be sure to buy back the losing stock within the 30-day wash sale period to trigger the wash sale rule, and again sell, but this time wait out the wash sale period. This will enable you to defer the loss from December to the following year when the gain is reported.