How the Wash Sale Rule Works
In general, no sale is allowed to be reported on your tax return in a calendar year if you purchase substantially identical property between the sale date and the date you reported the sale.
For most investors, stocks or mutual funds are the assets most likely to be subject to the wash sale rule, but any investment can be involved. In order to "wash" away any tax loss, you have to purchase a substantially identical security.
When determining if securities are substantially identical, a few factors are used to decide. Those include the same category, the same security type, and the same underlying security. However, if you purchased a stock or mutual fund that may have some of the same characteristics, it is not likely to be considered substantially identical. It is during the purchase date that these securities will be compared.
Once a sale has been identified as subject to the wash sale rule, a special tax adjustment needs to be made. Purchasers making this mistake will lose part of the tax benefits from the original sale.
It was to prevent you from buying a substantially identical security that triggered a capital loss that you could then use to offset another capital gain. In Capital Gains and Losses, you will find the terms to describe this tax situation.
Wash Sale Gray Areas
Like most of the government, you will find that the IRS has a series of gray area inconsistencies and there is often a fine line between what they approve of and what they don’t.
One such example and probably the best example of a gray area is the wash sale rule. In certain instances, it is okay to make investments which you then sell short and then make an investment of a similar value and deduct it from your tax return for that year. In some instances, the IRS will not disallow the deductions in these circumstances, but never in a million years will the IRS ever say that it is ok to make an investment, buy and sell it for a loss, design the rules to allow you to make another investment, and then claim that it is a different investment and the loss is a current year tax deduction. They’ll simply say that it is one investment and your loss can be used to offset a gain of a similar value in the current year.
What Happens if You Trigger the Wash Sale Rule?
The IRS’s so called wash sale rule states that you can’t deduct a loss on an investment, or on a valuable item that is used as part of another activity, if you purchased a ‘substantially identical’ investment or valuable item within 30 days before or after the sale, and if your purchase of the second investment or valuable item is intended to replace the first one.
In practical terms, this means that you cannot deduct a loss on a stock or investment if you buy back the very same stock or investment before the end of the 30-day period after the date of the sale.
There are two exceptions to the wash sale rule. By selling a covered security (stock or investment) at a loss, a taxpayer may be eligible for tax law’s favorable wash-sale rules that permit either a replacement purchase or a loss deferral.
The first exception involves a taxpayer who purchases a replacement property that is not a ‘substantially identical’ investment or a deductible transaction, known as a ‘safe harbor’ replacement.
The second exception involves a taxpayer who buys back the same security or investment he or she sold at a loss within 30 days but before the actual date of sale, because of a lower cost of the investment and not because of a substantially similar replacement, known as a ‘day-one sale’ exception.
The Bottom Line on the Wash Sale Rule
The wash sale rule means that you may have to recognize losses on a wash sale at any time. Prior to the Internal Revenue Service (IRS) issuing guidance, many taxpayers claimed capital losses and used the normal three-month limit to avoid the wash sale rule. However, the IRS has stated that taxpayers may treat the wash sale rule as a separate requirement from the substantially identical or substantially similar requirement when applying the loss disallowance rule.
The wash sale rule does not restrict you from selling or buying substantially identical or substantially similar property. What it does is stop you from claiming a loss on a wash sale. A wash sale is a sale of a security or property in which you have held an interest. A wash sale also occurs if you buy substantially identical or substantially similar property 30 days before or after the sale.
Nobody likes to recognize a loss. It is tough to swallow, especially when you consider that you may have turned that loss into a profit had you held on to the stock or mutual fund for a designated period of time. Younger investors especially like to recognize gains because they can let those gains compound, whereas losses are treated as a one-time expense.