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Wash Sale Rule
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
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Wash Sale Rule Examples
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.
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Don't lose out on your chance to offset short term capital gains by creating a wash sale situation.
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Avoid Wash Sales Preserve Capital Losses Deductions
Avoiding creating a wash sale is easy. Wait at least 30 days before repurchasing the same or substantially identical stock or securities. Of course, that isn't always practical.
However, there is a way to generate capital losses and re-purchase an investment without creating a wash sale in some cases.
Avoid Wash Sale Example #1:
Sell mutual fund shares and buy different mutual fund shares with same objective. For example, an investor could sell American Century Small Cap Value Fund (ASVIX) for a loss and then purchase Royce Opportunity Investment Fund (RYPNX) on the same day without generating a wash sale. The investments are certainly not the same, however, an investor will benefit from an upward move in small cap stocks in either fund.
Avoid Wash Sale Example #2:
Sell ETFs or Index Funds and buy shares in an ETF or Index fund that tracks a slightly different index. Avoid the temptation to try swapping around ETFs or Index Funds that use the same index. This could be trouble. However, selling a fund that tracks the S&P500 US Stock Index to purchase an ETF that tracks the S&P100 stock index will not create a wash sale.
Sell individual stocks and purchase the index that tracks the same sector. The value of individual stock selection comes from choosing winning companies. However, over a period of just 30 days, most individual stocks will not differ greatly in performance from their overall market sector, especially if there is no stock related news or reports. - This strategy should not be used during earnings season when stock performance can differ significantly from market performance.
For example, sell shares of Boeing stock and purchase an equal dollar amount of Dow Jones U.S. Aerospace & Defense Index ETF (ITA). Wait 31 days then sale ITA and purchase Boeing. If there is a loss on ITA during that time, you get an additional short-term loss to offset short-term gains with. If the market, or just that sector improve, you will not lose out on the move. (However, this will generate short-term gains. As with all investment strategies, the pros and cons must be weighed.)
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Wash Sale and Taxes
Taxes should never be the primary motivator for any investment decision. However, planning for taxes and tax minimization strategies year round is smart money management. Consider using these techniques only if there is a chance to avoid a substantial amount of tax liability, and never just to take advantage of a tax trick.
Calculate the value of getting the realized loss in NET DOLLARS before using any of these strategies. That will help you avoid making costly taxable mistakes for limited potential return. Calculating tax benefit in dollars is one strategy that too many investors neglect, don't be one of them.