Wash Sale Rules - Don't Lose Your Capital Losses Deduction

The IRS wash sale rule governs the treatment of capital gains and capital losses tax deductions for stocks sold and the re-bought within 30 days. Making sure you understand how wash sales affect short term capital gains is very important to minimize your potential tax burden. Inadvertently creating a wash sale situation will prevent you from offsetting short term capital gains with realized losses, potentially generating a big tax bill. To avoid taxes and save money, you'll need to be savvier than that.

The purpose of the stock wash sale rules is to prevent taxpayers from artificially creating realized losses by selling a stock position and recording a loss for that position and then re-purchasing the same position again as a "new" investment. In other words, stock wash sales can generate artificial realized losses which would undermine the ability of the IRS to collect capital gains taxes.

The official IRS wash sale rule can be found in IRS Publication 550 Investment Income and Expenses. It states that an investor cannot deduct losses from stock transactions that result in a wash sale. The definition of wash sale is:

• Repurchase the same (or substantially identical) stocks or securities
• Within 30 days of when the position was sold for a loss
• Also, if your spouse buys the same stock position within 30 days
• Also, if you buy the same stocks for your IRA or other tax-advantaged account within 30 days

Understanding about wash sale and taxes is best achieved via examples of wash sale transactions.

The most straight forward example of a wash sale is when an investor sells and then re-buys the same stock within 30 days.

Wash Sale Example #1

Joe buys 500 shares of XYZ stock at $50 per share. Unrelated market news drives the stock price down a few weeks later. The stock is now trading for $40 per share. Joe still wants to own XYZ stock as an investment, but wants to generate some realized short-term capital losses to offset realized short-term capital gains. He sells all 500 shares of XYZ generating a $5,000 capital loss. Ten days later, Joe buys 500 shares of XYZ stock, now trading at $45 per share.

This transaction is a wash sale an the entire $5,000 loss is disallowed. Joe cannot offset capital gains with the losses generated by the wash sale, further more, the basis of his new investment is adjusted according to IRS rules as documented in Publication 550.

Wash Sale Example #2

Joe has 500 shares of XYZ stock which he purchased as above. He sells all 500 shares at $40 per share generating a $5,000 capital loss. Joe's spouse purchases 300 shares of XYZ stock 25 days later.

In this case, a spouse purchased the stock, but that still creates a wash sale according to IRS rules. Since she only purchased 300 shares, however, not all of the loss is disallowed as a wash sale. In this case, the loss attributable to the sale of 300 shares is disallowed. The remaining realized capital loss of $2,000 is allowed and may be used to offset realized capital gains.

Note that wash sales cannot be avoided by having a spouse purchase the stock position. Also, wash sales cannot be avoided by buying stock option calls or any other method using contracts or options to lock-in the price of the security.