A wash sale is essentially a transaction where an investor maximizes tax benefits by selling any losing security at year’s end to enable them to claim a capital loss on taxes for that year.
The investor might intend to repurchase the security after the commencement of the new year, and even lower than what they sold.
Such wash sales are a way in which investors have recognized a tax loss without limiting their exposure in owning a specific security.
The IRS implements the wash-sale rule to decimate the incentive to sell and reacquire similar security within 30 days.
Some important points about wash sale that you need to know –
- A wash sale is triggered when an investor sells a security at a loss and repurchases substantially-similar security to claim tax benefits.
- The IRS keeps the traders in check in compliance with the wash sale rule to prevent misuse of wash sales.
- Investors who sell and then repurchase the same security within 30 days cannot count any capital loss on the transaction against any capital gain.
Wash Sales – A Deeper Insight
A wash sale occurs when a country’s tax laws allow tax deductions for losses on securities that are held within a given tax year.
Without such incentives, wash sales would not be needed. However, where such incentives prevail, wash sales also inevitably occur. The wash sale has three parts –
- When investors observe they are losing a position at the end of a tax year, that position is closed by them at or near the year’s end.
- The sale enables them to bear a loss, which they can claim legally on their tax returns as a reduction of their earnings for the year. This way, they pay a lesser amount of taxes.
- After the beginning of the new year, the investors seek to purchase the security at or less than the price they sold previously.
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The Wash-Sale Rule
To prevent this incentive’s misuse, the Internal Revenue Service (IRS) enforced the Wash-Sale Rule in the U.S.
This rule implies that if an investor invests in a security within 30 days after selling it, then any losses made from that sale won’t be added against reported income.
The IRS does not generally consider bonds or preferred stock of an issuing company as being substantially identical to the company’s common stock.
However, there may occur circumstances where the preferred stock might be regarded as being substantially identical to the common stock.
This would occur if the preferred stock is convertible into common stock without any restrictions, possesses the same voting rights as the ordinary stock, and trades at a price near to the conversion ratio.
Traders must note that not all loss realized on a wash sale is completely lost. However, the loss can be applied to the cost basis of the latest purchased substantially identical security.
Not only does this addition elevate the cost basis of the purchased securities, but it also mitigates the size of future taxable gains. Hence, the investor still gains credit for those losses, but at a later period.
The holding time of the wash sale securities is included in the holding period of the repurchased securities, increasing an investor’s chances of qualifying for the 15% favorable tax rate over long-term capital gains.
As per Revenue Ruling 2008-5, IRA transactions also can trigger the wash-sale rule.
If shares are sold-off in a non-retirement account and almost substantially identical shares are bought in an IRA within a 30-day time, the investor is unable to claim tax losses for the sale.
Tips To Steer Clear Of Wash Sales
You can avoid a wash sale on a particular stock while still keeping your exposure to the industry of the stock sold at a loss by substituting a mutual fund or simply an exchange-traded fund (ETF) that targets a similar industry.
ETFs can be helpful to help avoid the wash-sale rule when it comes to selling a stock at a loss.
Unlike the ETFs that focus on broad-market indexes, such as the S&P 500, some ETFs emphasize on a particular industry, sector, or other narrow groups of stocks.
These ETFs can also provide an amazing way to regain exposure to the industry of a stock you just sold; however, they typically hold enough securities that they clear the test of not being substantially identical to any particular stock.
Swapping an ETF for another ETF, a mutual fund for another mutual fund or even an ETF for a mutual fund can be tricky due to the security rule of being substantially identical.
There are no specified guidelines as to what constitutes a substantially identical security. The IRS reviews if your transactions violate the wash-sale rule. This could lead to you paying higher taxes for the year.
Tax Loss Harvesting
You sell-off your stocks at a loss to reduce your tax liability liable on your capital gains made by selling profitable stocks.
Tax Loss Harvesting, if exercised properly, can help you save taxes. Once you have sold the losses, you have to wait for 30 days before you invest in a similar stock.
Taxpayers take-the-edge-off of their capital gains to reduce their overall taxes paid. After selling their stocks at a loss, investors seek to purchase the same or substantially-identical stocks to replace the loss incurred.
Tax loss harvesting is yet another method to avoid triggering wash sales and saving your taxes at the same time.
To harvest a tax loss successfully, you must monitor your asset allocations and also ensure that the replacement assets purchased aren’t substantially identical.
Tax loss harvesting is effective to steer clear of wash sales and minimize your taxes to be paid on capital gains.
The wash-sale rule helps the IRS limit stock sales that are promoted due to tax reasons. This rule prohibits traders from claiming false losses while filing for their taxes.
Investors often avoid it to reduce taxes or usually figure out some ways to work around a wash sale. However, you must always maintain a clean portfolio.
Understanding the trade-offs can help you achieve success in trading and tread the path keeping wash sales in mind.