What Is a Wash Sale?
A wash sale is an Internal Revenue Service (IRS) rule that prohibits investors from claiming a tax deduction for a loss on the sale of a security if they repurchase a "substantially identical" security within a 61-day period, which includes 30 days before and 30 days after the sale date, as well as the sale date itself. This critical concept in Investment Taxation is designed to prevent investors from artificially generating capital losses to offset capital gains or ordinary income, without genuinely altering their investment portfolio. The wash sale rule applies to stocks, bonds, options, and other securities.
History and Origin
The wash sale rule was formally introduced in the United States as part of the Revenue Act of 1921. Its primary purpose was to prevent taxpayers from manipulating the tax system by creating artificial tax losses. Before this rule, investors could sell a losing security, immediately repurchase it, and claim the realized loss for tax purposes while maintaining continuous exposure to the asset. This practice allowed individuals to reduce their tax liability without any significant change in their economic position. The rule has since been codified in Section 1091 of the U.S. Internal Revenue Code19. Congress made a significant change in 1954 by adding the "substantially identical" requirement, broadening the rule's scope beyond just identical securities18. In 2013, the IRS introduced a rule requiring brokers to report wash sales, making enforcement more straightforward17.
Key Takeaways
- A wash sale occurs when a security is sold at a loss, and the same or a "substantially identical" security is purchased within 30 days before or after the sale date.
- The wash sale rule prevents investors from deducting losses from such transactions for tax purposes.
- Disallowed losses are not permanently lost; instead, they are added to the cost basis of the newly acquired security, potentially reducing future capital gains or increasing future losses.
- The rule applies across all an investor's accounts, including IRAs and those of a spouse16.
- Understanding and avoiding wash sales is crucial for effective Tax-Loss Harvesting strategies.
Formula and Calculation
When a wash sale occurs, the disallowed loss is added to the cost basis of the newly acquired, substantially identical security. This adjustment ensures that the tax benefit of the loss is deferred rather than eliminated. The formula for the new adjusted cost basis is:
Additionally, the holding period of the original security is added to the holding period of the newly acquired security for determining long-term or short-term capital gains/losses.
For example, if an investor sells 100 shares of Company A stock for $800, incurring a $200 loss (original cost basis $1,000), and then buys 100 shares of Company A stock for $850 within the wash sale period, the $200 loss is disallowed. The adjusted basis of the new shares becomes:
This $1,050 becomes the new basis for tax purposes when the investor eventually sells these new shares.
Interpreting the Wash Sale
The interpretation of the wash sale rule primarily revolves around the concept of "substantially identical" securities and the 61-day window. While the 30-day before-and-after period is clear, what constitutes "substantially identical" is often less precise. The IRS and courts generally consider factors such as the issuer, type of security, and underlying rights and obligations15. For instance, common stock of the same company is clearly substantially identical. However, determining if an option to buy a stock is substantially identical to the stock itself, or if an ETF tracking a broad market index is substantially identical to another ETF tracking the same index, requires careful consideration of the specific facts and circumstances14.
Investors must also be aware that the rule applies across all their accounts, including traditional and Roth IRAs, and even accounts held by a spouse13. A wash sale can occur if an investor sells a security at a loss in a taxable brokerage account and their spouse purchases a substantially identical security in their IRA within the prohibited window. It is the investor's responsibility to track these transactions across all accounts, as brokers generally only report wash sales within the same account for identical CUSIP numbers12.
Hypothetical Example
Consider an investor, Sarah, who purchased 100 shares of XYZ Corp. for $50 per share, totaling $5,000. On October 1st, the stock price has fallen to $40 per share, and Sarah sells all 100 shares for $4,000, incurring a capital loss of $1,000.
To avoid the wash sale rule, Sarah would typically need to wait at least 31 days before repurchasing XYZ Corp. stock or a substantially identical security. However, if Sarah believes the stock will rebound quickly and buys back 100 shares of XYZ Corp. on October 15th for $42 per share, this triggers a wash sale.
Because it is a wash sale, Sarah cannot claim the $1,000 loss on her tax return for the current year. Instead, this disallowed loss is added to the cost basis of the newly acquired 100 shares. The new adjusted cost basis for these shares becomes $4,200 (purchase price) + $1,000 (disallowed loss) = $5,200. When Sarah eventually sells these new shares, her gain or loss will be calculated based on this adjusted basis of $5,200, effectively deferring the recognition of the initial $1,000 loss.
Practical Applications
The wash sale rule primarily impacts investors attempting to engage in tax-loss harvesting, a strategy where investors sell losing investments to offset gains and potentially reduce ordinary income by up to $3,000 annually. To successfully harvest losses, investors must ensure that any repurchase of a similar investment falls outside the 61-day wash sale window.
For instance, an investor selling shares of a particular S&P 500 ETF at a loss could buy a different S&P 500 ETF from another provider, or an ETF tracking a different but correlated index (e.g., a Russell 1000 ETF), provided they are not considered "substantially identical" by the IRS11. This allows the investor to maintain market exposure while still realizing a tax loss. Brokerages are required to report wash sales to the IRS on Form 1099-B10. This helps the IRS monitor compliance and ensure that individuals do not improperly claim tax deductions. Financial advisors frequently educate their clients about the nuances of the wash sale rule to optimize their tax planning strategies within legal boundaries.
Limitations and Criticisms
While designed to prevent tax abuse, the wash sale rule has several limitations and points of criticism. One significant area of ambiguity is the definition of "substantially identical." The IRS does not provide an exhaustive list, leaving investors and their advisors to interpret specific situations, particularly with complex instruments like certain mutual funds, ETFs, or dividends being reinvested8, 9. This ambiguity can lead to unintentional wash sales, where an investor unknowingly repurchases a substantially identical security.
Another critique is that the rule can complicate legitimate portfolio management strategies. For example, if an investor sells a stock at a loss and then has dividends automatically reinvested into the same stock within the 30-day window, it can trigger a wash sale for the reinvested portion, disallowing part of the original loss7. Furthermore, the rule applies even if the intent was not tax manipulation, but rather a genuine change of mind or a desire to re-enter a position at a lower price. Some argue that the rule, while necessary for preventing outright abuse, places an undue burden on individual investors to track complex cross-account transactions and interpret vague definitions5, 6.
Wash Sale vs. Tax-Loss Harvesting
The terms "wash sale" and "Tax-Loss Harvesting" are closely related but represent opposite outcomes in tax planning.
| Feature | Wash Sale | Tax-Loss Harvesting |
|---|---|---|
| Definition | A transaction where a security is sold at a loss, and a substantially identical security is repurchased within 30 days before or after the sale date (61-day window). | The strategic sale of investments at a loss to offset capital gains and potentially a limited amount of ordinary income for tax purposes. |
| Tax Implication | The loss from the sale is disallowed for current tax deduction, but added to the cost basis of the new security. | The loss from the sale is allowed as a deduction against capital gains and potentially ordinary income, reducing current tax liability. |
| Intent | Often unintentional, occurring when an investor re-enters a position too quickly, or through automatic dividend reinvestment, but can be a deliberate attempt to maintain exposure while realizing a loss. | Deliberate strategy to optimize tax outcomes, often by selling a losing asset and replacing it with a non-substantially identical, but economically similar, asset to maintain diversified investment portfolio exposure. |
| Result | Defers the tax benefit of the loss to a future sale. | Provides an immediate tax benefit by reducing current taxable income. |
In essence, a wash sale is what you want to avoid when you are trying to achieve tax-loss harvesting. Successfully tax-loss harvesting requires careful adherence to the wash sale rule's parameters, specifically the 61-day waiting period for substantially identical securities.
FAQs
1. Does the wash sale rule apply to cryptocurrencies?
No, as of the current tax laws, the wash sale rule generally does not apply to cryptocurrencies. The IRS classifies cryptocurrencies as property, not as "stocks or securities," which are explicitly covered by the wash sale rule. However, tax laws are subject to change, so investors should stay informed.
2. What happens if I violate the wash sale rule?
If you violate the wash sale rule, you cannot deduct the capital loss from that sale in the current tax year. Instead, the disallowed loss is added to the cost basis of the newly acquired, substantially identical security. This adjustment effectively defers the recognition of the loss until you sell the new security, potentially reducing a future capital gain or increasing a future capital loss from that security.
3. How do I report a wash sale on my taxes?
If you have a wash sale, your brokerage typically reports the disallowed loss on Form 1099-B, often in Box 1g, or through a supplementary statement3, 4. You generally report the original sale on Form 8949, and then adjust the cost basis of the repurchased shares according to IRS guidelines. For complex situations, consulting a qualified tax professional is advisable.
4. Does the wash sale rule apply if I buy the stock in a different account?
Yes, the wash sale rule applies across all your accounts, including taxable brokerage accounts, IRAs, and even accounts held by your spouse2. For example, if you sell a stock at a loss in your individual brokerage account and repurchase a substantially identical stock in your Roth IRA within the 61-day window, it is still considered a wash sale. It is the investor's responsibility to track these transactions across all their holdings.
5. What if I sell only part of my shares at a loss and then repurchase?
If you sell only a portion of your shares at a loss, and then repurchase shares within the wash sale window, only the loss corresponding to the number of repurchased shares will be disallowed. For example, if you sell 100 shares at a loss and repurchase 50 shares, only the loss from those 50 shares is disallowed and added to the adjusted basis of the new 50 shares1.