This article was last updated on June 10, 2022
So, you’re thinking of taking up trading as a hobby. However, before you can do so, there are several important rules and laws that you should consider. Learning these early on is crucial to your success and can save you a lot of headaches later down the line. One such law is the so-called “Wash Sale Rule,” which aims to prevent traders from taking advantage of tax deduction benefits. However, it is also a common pitfall for unsuspecting newcomers.
In this article, we will outline what the wash sale rule is. What its purpose is. And how you can avoid falling victim to it. Read on to save yourself a possible visit from the IRS, which, honestly, no one enjoys.
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What Is A Wash Sale?
A “Wash Sale” occurs when you sell a stock or other asset at a loss and then purchase another one of the same kind, or similar enough, within 30 days. Since you quickly bought the new one, the price would be almost the same as what you sold the first one for. As the two prices are so similar, there would barely be any difference in your portfolio.
However, this is where the wash sale mechanic comes into play. The United States Internal Revenue Service (IRS) allows private individuals to file for up to $3,000 in realized losses and deduct them from their yearly taxes. If they have lost more than $3,000, the excess can also be deducted. However, it will carry over to the following fiscal years in increments of up to $3,000.
Married couples can also take advantage of this offer by filing together for a shared total of $3,000 per year. Alternatively, they can file separately and be eligible for a $1,500 deduction each.
As a result, many people can exploit the $3,000 deduction offer by performing wash sales. Since the actual losses they incur from the sale are minimal, the filed losses do not match the real ones. This would then mean that any gains declared during that year would benefit from the $3,000 deduction.
What Is The Wash Sale Rule?
To combat people exploiting this loophole, the government has introduced the “wash sale rule.” This law prevents citizens from declaring losses from assets if they have purchased a similar asset within a 61 day period around the sale that resulted in the loss. The rule applies not only to individuals but also to their legal spouses and any companies they may own or operate.
If, for example, you bought 1,000 shares of a company for $10 per share and later sold these for a price of $7 per share, you would have lost $3,000 in total. This can be filed and deducted from your tax returns. However, if you have purchased a substantially identical asset of the same price within 30 days prior to or following the sale, your losses would be nearly zero and would not match the declared ones. Since the two assets are so similar, their values would move alongside each other.
The rule applies across all of your investing and savings accounts, so you cannot subvert it by making transactions through different platforms. If you purchase one asset through your brokerage account while the other is acquired from your retirement account, the IRS still sees them as made by one individual and will not allow you to declare the loss.
However, not everyone has malicious intent in mind, and it is easy for unsuspecting investors to get caught up in this.
Who Decides What Constitutes Substantially Identical Assets?
At this point, you might be wondering who decides if two assets are identical and fall under the wash sale rule. Well, there is no exact definition of “substantially identical assets.” The IRS introduced the term in relation to the wash sale rule and has provided a broad outline of what it encompasses. However, the specifics and the final decision are up to the organization. If they decide that your investments fall under the rule, that’s it.
Generally, substantially identical assets can include common stocks and convertible securities of the same corporation. Shares of the same company with different classes also count. Let’s take the latter example. You can sell class A shares of a given company at a loss and then buy class B shares of the same company. Because the assets are related to the same company, their movements would be identical, and the IRS would consider this a wash sale. If, however, they purchased stocks from a different company that is closely related, it would not fall under the wash sale classification.
Meanwhile, selling an ETF of a market index at a loss and then buying another one of the same index under a different manager would be ok. This does not qualify as a wash sale in the eyes of the IRS. This practice is called “Tax-Loss Harvesting,” and many investors utilize it to offset their losses. While not illegal, many consider it to be a loophole and advocate for its removal.
What Is The Penalty For Breaking The Wash Sale Rule?
Let’s say that you sell a stock at a loss and buy a substantially identical one within 30 days. In such cases, the IRS will not allow you to declare the loss from the sale in your tax return. If you have filed such a loss, you will likely receive a letter that disallows it. However, what you can do is add that loss to the base price of the second asset. This means that if you later sell it for a profit, you can calculate the net income by deducting this higher price. Alternatively, if you sell it at a further loss, this will also be calculated using the new price. As a result, you will receive a larger tax deduction when filing it.
For example, you purchase stocks for $10,000 at $100 a share. If you sell them at $70 per share, that would be a $3,000 loss. However, if you purchase a substantially identical one for $50 per share before the 30 day period expires, you will not be able to deduct the loss. What you can do in this situation is add the loss to the base price of the second purchase. This would raise it from $50 to $80 per share for tax purposes. If you later sell the stock for $100 per share, you can declare a net income of $20 per share. As a result, your reported income would be lower, and so will be your owed taxes.
On the off chance that wash sale has somehow gotten past the IRS, they will usually notice it sooner or later. In such cases, they will require you to pay retroactively for back taxes. Additional charges may also be accrued due to the delay and failure to report.
How Can I Avoid Wash Sales?
As a general rule of thumb, there are several factors that you should be mindful of. These will help you avoid unwittingly breaking the wash sale rule. Don’t forget to also check out our extensive guide on the top 5 crypto-friendly banks in the US.
- Do your research. When trading, you should always know what you are investing in. Some assets might be much more connected than you think. This can lead to you carrying out wash sales without even knowing it. However, if you are familiar with the companies you invest in, you will avoid such missteps.
- Keep track of your investments. If you have a diverse and extensive portfolio, it can sometimes get difficult to manage your investements. This is especially true if you use an automated trading tool. Such programs can quickly buy and sell assets instead of you. While handy, if left unatended, issues like wash sales can arise.
- Wait for the 30 day rule to expire. Sometimes the best solution is the simplest. If you want to buy a related asset to the one that you sold, wait for the required period to go by. Otherwise, you will not be able to deduct the loss from your taxe return.
- Choose the right alternative. Sometimes, you can buy a very similar asset which the IRS does not consider to be substantially identical. This goes back to the example of index ETFs managed by different organizations. There are several such cases which can be used to subvert the rule while still remaining in the market. If you are unsure wheter an asset is different enough, you can always consult a financial advisor.
- Trade cryptocurrencies. While incredibly popular, cryptocurrencies are a relatively young market. Currently, they do not fall under the wash sale rule. This means that you can buy and sell them as much as you like. However, congress has taken notice of this and is moving to change regulation. If you would like to take advantage of the loophole, you should probably try it sooner rather than later.
The Bottom Line
While not the scariest law, the wash sale rule is certainly something to be on the lookout for. Taking advantage of loss tax deductions is an integral tool in every trader’s belt. It helps to offset losses accrued over the year and maximize gains. Learning how to avoid falling prey to this snare is very important to your success in the trading world. And, just like most things trading-related, research is your best option. Learn how not only how to avoid breaking the rule but also how to turn it to your advantage. Loopholes like tax-loss harvesting can be very powerful when utilized properly.