What is a Wash Sale?
A wash sale is categorized when an investor sells a stock or security and repurchases the same or a substantially identical security within 30 days of the sale. The US Internal Revenue Service (IRS) introduced the 61-day wash sale rule to prevent investors who hold unrealized losses and want to benefit from a tax deduction.
In a wash sale, the investor repurchases the security within 30 days with the hope of regaining the value of the security, which will become taxable in the next financial year. The 61-day wash sale rule comprises 30 days before and after the date of sale.
Wash sale rule explained
A wash sale comprises two transactions, i.e., the sale of a security at a loss and the repurchase of the security within 30 days before or after the sale. The purchase may include either of the following options:
- Purchase of another substantially identical security for an individual retirement account
- Purchase of the same or a substantially identical security
- Purchase of an option or contract to buy substantially identical security
- Purchase of a substantially identical security in a fully taxable transaction
If an investor purchases the same or a substantially identical security within the 61-day time frame, the IRS disallows the transaction, and the amount of loss is added to the cost of the replacement security. It defers the loss until a future time when the replacement security is sold. The 61-day holding period also applies to the replacement security. The “substantially identical security” is also referred to as the “replacement security” for the original security.
What constitutes a wash sale
There several things that the IRS considers when deciding whether a certain transaction qualifies to be a wash sale transaction. First, securities in different classes are not considered substantially identical to each other. For example, bonds and preferred stock are considered to be different from common stock, and the IRS treats them differently. The only exception to this provision is when preferred stock can be converted to common stock without any restriction, and they both trade at a price that is close to the conversion ratio. The IRS does not consider stocks sold by one company to be substantially related to the stocks purchased by another company.
With these provisions, investors can use certain methods to keep trading until the wash sale period has lapsed. One way that investors can achieve this is to sell one type of security at a loss and buy a different type of security in the same industry until the period has expired, and then repurchase the original type of security.
For example, an investor can sell 1,000 stocks of ABC Company, a manufacturing company, at a loss and use the funds to buy a mutual fund in the manufacturing sector during the wash sale period. After the period has expired, the investor can sell the mutual fund and repurchase the original common stocks of ABC Company if the investor wants to regain the original position. Repurchasing ABC’s shares after the wash sale period allows the investor to claim losses and realize tax deductions.
Practical example: Wash sale
Assume that Jay purchased 100 shares of ABC Company for $30 per share and sold them for $27 per share on July 20. He then repurchased the shares on August 10 when the shares were trading at $33 per share. Since the transaction occurred within the 30-day wash sale period, the $300 loss is a wash sale and would be disallowed by the IRS. The adjusted basis for the replacement shares is $3,600, which is the addition of the $3,300 ($33 x 100) and the $300 loss that was disallowed. Therefore, the loss is counted as a wash sale as though Jay retained the original shares.
Adding the loss to the replacement cost basis is beneficial to the investor from a tax perspective. If the investor sells the shares at a profit, he will realize more capital gains. Since the holding period of the wash sale security is added to the holding period of the repurchased securities, the investor stands a chance to qualify for a favorable tax rate on capital gains.
Same stocks vs. or Substantially identical stocks
When determining the transactions that are counted as wash sales, the IRS uses the terms “same stocks” or “substantially identical stocks” to determine if investors can claim artificial losses. Two securities are identified as same if they are exactly identical or if they share most of their characteristics.
For example, a company’s bonds and preferred stock are considered different from the same company’s common stock. Also, the securities of one company, e.g., ABC Company, are not identical to the stocks of another company, e.g., XYZ Company.
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