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Tax costs for poorly timed stock transactions

Taxes » Tax Credits » Tax Costs For Poorly Timed Stock Transactions

Your portfolio took a beating, but you were able to use that to your tax advantage by selling some losers. Now one of your former stocks has turned around and you want it back.

Don't be in too big of a hurry to call your broker. If you repurchase the stock too soon, you'll violate the wash sale rule. This regulation prohibits a shareholder from selling a holding at a loss, using that loss for a tax break and then turning right around and buying the same or similar stock.

It's designed to prevent the deduction of what the IRS calls "noneconomic losses." Essentially, in the eyes of the Internal Revenue Service you never really sold the stock. Your repurchase indicates to the tax agency that you believe in the investment itself but the whole purpose behind the transaction was to generate a tax loss. "You just sold it to book that tax loss, and the Internal Revenue Service is not going to let you do that," says Jim Van Grevenhof, senior tax analyst from the Tax & Accounting business of Thomson Reuters.

Most investors encounter the regulation when they reacquire a stock soon after selling, but it works the other way, too.

Specifically, the law says you may not take a tax loss on a security sale if you have obtained the same or a substantially identical security 30 days before or 30 days after a sale. So don't try to get around the rule by buying more of a stock just before you dump the poorly performing shares you already own.

No loss now, but later

When a stock transaction violates wash sale guidelines, the IRS will not let you take the tax break immediately. However, all is not lost.

For tax purposes, the deduction of your loss is postponed to a later date. That is, the disallowed loss is added to the cost of the new shares you bought. This gives you the tax basis for the holdings, which you'll use when you sell the reacquired securities.

For example, Joe bought 100 shares of Stock A for $1,000 and sold them for $750, producing a $250 loss. Fifteen days later he bought 100 new shares of Stock A for $800. Because Joe bought identical stock, he can't immediately take the loss. But he can add the disallowed $250 to the $800 price of his new shares, producing a basis of $1,050 for the new shares. When Joe sells his reacquired Stock A shares, the adjusted basis will, depending on the sales price, produce a bigger loss to claim or reduce any taxable gains.

And don't try to skirt the rule by buying a call option on the stock. "Say I bought a stock at $30, it went down to $20 and I want to sell it and claim the $10 loss. Then a day or two later, I buy a $20 call on the stock," says Van Grevenhof as way of illustration. "What I hope is that the stock will go up. That's the same thing as buying actual stock and it violates the wash sale rules."

What exactly is identical?

The wash sale timing considerations are pretty straightforward. That's not necessarily the case for the rule's other key component: the nature of the sold and repurchased stock.

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