Wash sale rule

What Is Wash Sale Rule?

The wash sale rule is an Internal Revenue Service (IRS) regulation that disallows a tax deduction for a realized loss on the sale of a security if a "substantially identical" security is purchased within 30 days before or after the sale. This 61-day period (30 days before, the day of the sale, and 30 days after) is often referred to as the wash sale window. The primary purpose of the wash sale rule, a core component of tax and investing regulation, is to prevent investors from artificially generating losses for tax purposes without truly changing their economic position in the financial markets. If a transaction is identified as a wash sale, the disallowed loss is not forfeited; instead, it is added to the cost basis of the newly acquired, substantially identical security.

History and Origin

The wash sale rule was first introduced in the United States by the Revenue Act of 1921, a legislative effort aimed at preventing taxpayers from exploiting loopholes to reduce their taxable income through manufactured losses¹¹, ¹². The intent was to ensure the integrity of the tax system by disallowing deductions for losses that did not reflect a genuine economic change in an investor's position. The legal foundation for the wash sale rule is codified in U.S. tax law under 26 U.S. Code § 1091. Over time, the rule has been clarified and updated, with significant changes in 1954 to include the "substantially identical" provision, and later in 2013, when the IRS began requiring brokers to report wash sales.¹⁰

Key Takeaways

The wash sale rule prevents investors from deducting a loss on the sale of a security if they buy a "substantially identical" security within 30 days before or after the sale date.
This rule applies to most securities, including stocks, bonds, mutual funds, and exchange-traded funds (ETFs) held in a taxable brokerage account.
If a loss is disallowed under the wash sale rule, it is 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 can even apply if a spouse purchases the substantially identical security.⁹
Understanding the wash sale rule is crucial for effective tax-loss harvesting strategies.

Interpreting the Wash Sale Rule

Interpreting the wash sale rule primarily involves understanding its impact on tax-loss harvesting, a strategy used to offset capital gains with capital losses. When a wash sale occurs, the disallowed loss cannot be used to reduce an investor's current-year taxable income. However, this loss is not permanently lost. Instead, it is added to the cost basis of the repurchased security. This adjustment means that while the immediate tax benefit of the loss is deferred, it will effectively reduce the capital gain or increase the capital loss when the replacement security is eventually sold. For example, if an investor sells shares at a $500 loss but triggers the wash sale rule, and then repurchases the same shares, the original $500 loss is added to the new shares' cost basis. This higher cost basis will lead to a smaller taxable gain or a larger deductible loss upon the subsequent sale of the new shares.
⁷, ⁸
The concept of "substantially identical" is key to interpreting the wash sale rule. While identical shares of the same company are clearly covered, "substantially identical" can extend to convertible bonds of the same issuer, or certain options and warrants. However, generally, shares of a different company, even in the same industry, or ETFs tracking different indices, are usually not considered substantially identical.⁶

Hypothetical Example

Consider an investor, Alex, who owns 100 shares of ABC Corp. stock.

Original Purchase: On January 1, Alex bought 100 shares of ABC Corp. at $100 per share, totaling $10,000.
Sale for a Loss: On June 1, the stock market declines, and Alex sells all 100 shares of ABC Corp. at $80 per share, incurring a realized loss of $2,000 (($80 - $100) * 100 shares).
Repurchase: On June 15 (14 days after the sale), Alex still believes in ABC Corp.'s long-term prospects and repurchases 100 shares of ABC Corp. at $85 per share.

Because Alex repurchased a substantially identical security (the same ABC Corp. stock) within the 30-day window after selling it at a loss, this transaction is a wash sale. The $2,000 loss from the June 1 sale is disallowed for tax purposes in the current year. Instead, this $2,000 disallowed loss is added to the cost basis of the newly acquired shares. So, the new cost basis for Alex's 100 shares bought on June 15 becomes $8,500 (purchase price) + $2,000 (disallowed loss) = $10,500, or $105 per share. When Alex eventually sells these new shares, the gain or loss will be calculated using this adjusted cost basis.

Practical Applications

The wash sale rule has significant practical applications for investors, particularly those engaged in active portfolio management and tax planning. It directly impacts strategies like tax-loss harvesting, where investors intentionally sell investments at a loss to offset capital gains and potentially reduce their taxable income by up to $3,000 against ordinary income annually.⁵

To avoid triggering the wash sale rule while still aiming for tax benefits, investors often employ specific investment strategies. One common approach is to wait the full 31 days after selling a security at a loss before repurchasing the same or a substantially identical one. Alternatively, investors might sell a losing security and immediately buy a non-"substantially identical", but similar, security (e.g., selling an S&P 500 ETF and buying a total stock market ETF) to maintain market exposure while adhering to the rule.⁴ The Internal Revenue Service provides detailed guidance on this rule in IRS Publication 550, "Investment Income and Expenses (Including Capital Gains and Losses)".

Limitations and Criticisms

One of the main limitations of the wash sale rule is its complexity for individual investors. While brokers generally report wash sales that occur within a single brokerage account for identical securities, it is ultimately the investor's responsibility to identify and account for all potential wash sales across all their accounts, including those at different firms, or even within IRAs or a spouse's account.³ This can be particularly challenging for active traders or those with multiple accounts, increasing the risk of unintentional non-compliance.

Furthermore, the "substantially identical" clause can sometimes be ambiguous, leading to confusion about which securities truly fall under its purview. While the Internal Revenue Service provides examples, the interpretation can still be subjective in certain complex scenarios involving derivatives, selling short, or less common investment vehicles. The rule's primary criticism revolves around the administrative burden it places on investors seeking to legitimately manage their tax liabilities, especially those employing day trading or other high-frequency strategies. Despite these complexities, the rule remains a fundamental part of the U.S. tax code, designed to prevent abuse of capital loss deductions.

Wash Sale Rule vs. Capital Loss

The wash sale rule and capital loss are closely related but distinct concepts. A capital loss occurs when an investment is sold for less than its adjusted cost basis. Generally, capital losses can be used to offset capital gains and, to a limited extent, ordinary income, thereby reducing an investor's tax liability.

The wash sale rule is an IRS provision that disallows a capital loss under specific circumstances. If an investor sells a security at a loss and then buys a "substantially identical" security within the 61-day wash sale window, the capital loss from the original sale cannot be claimed for tax purposes in that year. Instead, the disallowed capital loss is added to the cost basis of the newly acquired security. Therefore, while a capital loss is a fundamental outcome of selling an asset for less than its purchase price, the wash sale rule determines whether that capital loss is immediately deductible for tax purposes. Without the wash sale rule, investors could easily sell a losing stock, claim the capital loss, and then immediately repurchase the same stock, effectively maintaining their market position while receiving a tax benefit.

FAQs

What assets does the wash sale rule apply to?

The wash sale rule applies to stocks, bonds, mutual funds, exchange-traded funds (ETFs), options, and other securities held in taxable investment accounts. It generally does not apply to cryptocurrencies, as the Internal Revenue Service currently classifies them as property rather than securities.²

How long do I have to wait to avoid a wash sale?

To avoid triggering the wash sale rule after selling a security at a loss, you must wait at least 31 days before repurchasing the same or a "substantially identical" security. This 31-day period ensures you are outside the 30-day "before" and 30-day "after" window that surrounds the sale date.

Can a wash sale occur across different brokerage accounts?

Yes, a wash sale can occur across different brokerage accounts, including those held at different firms, or even between a taxable account and a retirement account like an IRA. The rule applies to the taxpayer, not just to a single account. It's the investor's responsibility to track all relevant transactions to ensure compliance.
¹

What happens if I accidentally trigger a wash sale?

If you accidentally trigger a wash sale, the realized loss from the sale is disallowed for tax purposes in the current year. However, this disallowed loss is added to the cost basis of the newly purchased, substantially identical security. This adjustment defers the tax benefit of the loss until the replacement security is eventually sold, at which point the higher cost basis will reduce your taxable gain or increase your deductible loss.