Wash sale

Wash sale is an investment term it pays to understand. Here’s what it means.

What is a wash sale?

A wash sale refers to the selling and repurchasing of an asset within a short period of time. Investors typically employ this method to recognize a tax loss without actually changing their positions.

Deeper definition

A wash sale involves selling a security, such as stocks, bonds or options, at a loss and purchasing the same stock in a very short period of time. This transaction typically occurs near the end of the fiscal year. A wash sale is designed to create a capital loss, which can be claimed on the tax return for the covered period. The idea is to offset the entire capital gains for the fiscal year, while keeping the security in the investment portfolio for future use.

In the United States, under the Internal Revenue Code (IRC), a wash sale occurs when a taxpayer:

  • Sells or trades securities at a loss within 30 days before or after the day of sale.
  • Purchases substantially identical securities.
  • Obtains a contract or option to purchase substantially identical securities.
  • Purchases substantially identical stock for an IRA.

The federal government enacted a wash-sale rule, which authorizes the IRS to prohibit taxpayers from deducting losses on the sale of an investment if they purchase the same security 30 days before and after the sale. This means that the wash-sale rule time period lasts for 61 calendar days (30 days before and after the sale, plus the day of sale).

The IRS wash-sale rule has greatly reduced the wash-sale strategy. Claiming tax deductions that result from wash sales is prohibited. Investment losses are typically tax-deductible, but selling stocks, bonds and other securities at a loss and immediately repurchasing them gives fake tax deductions to tax evaders without changing their positions in a security.

The wash sale has three consequences:

  • An individual is prohibited from claiming the loss on his sale.
  • The prohibited loss is added to the basis of the replacement stock.
  • The holding period for the replacement stock includes the period that an individual held the stock he sold. For instance, say an investor held shares of Twitter for 10 years. He sells it at a loss, but then purchases it back within the wash sale period. When he sells the replacement stock, his gain or loss will be long-term, regardless of how soon he sells it.

Examples of a wash sale

A basic wash sale occurs when a security is sold at a loss and repurchased before or after the loss. For instance, an investor buys 100 shares of Facebook stocks for $5,000 on May 1. On July 7, he sells those 100 shares of Facebook stock for $4,500. On July 16, he purchases 150 shares of Facebook for $4,750. Because he purchased substantially identical stock within 30 days of the sale of Facebook stocks, it’s a wash sale and the loss of $500 on the sale of Facebook can’t be deducted. The loss is generally deferred and applied to the cost basis of the new tax percentage. The wash sale in this example would increase the cost basis of the new lot from $4,750 to $5,250.

If a taxpayer sells a stock and his spouse (if they file jointly) or a company he controls buys a substantially identical stock, he also has a wash sale. In this case, the IRC indicates that losses from the sale of stock can’t be recognized at the time of sale. Instead, they must be deferred.

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