Navigating the tax consequences resulting from the sale of investments is crucial to your success as an investor. You don’t have to be a CPA, but you do have to have a base level of tax-related knowledge. This includes the lesser-known wash sale rule. (We’ll come back to this in a minute).
We’ll start by saying that most people are aware that selling investments at a gain will result in a capital gain. However, not everyone knows what happens when you sell an investment at a loss.
Under current tax law, investors are eligible to claim a deduction from their income based on net capital losses realized in taxable accounts. Note that losses in tax-deferred accounts such as 401Ks, IRAs, etc. cannot be deducted from your income.
The IRS allows you to deduct up to $3,000 of net capital losses in taxable accounts from your ordinary income in the tax year that the losses occurred. If you have more than $3,000 worth of net capital losses, the excess is carried forward to future tax years. The deduction can continue until the carry-forward is exhausted.
As you can see, there may be a silver lining to capital losses, although you should still focus on growing your net worth.
There are instances, however, where the capital loss may be a “wash,” which means that the loss cannot be claimed. This is the “wash sale rule.”
After reading this article, you will know what the wash sale rule is, how it works, and how you can avoid it.
Before we continue, Financial Professional wants to remind you that this article is educational in nature. Any securities or firms named are for illustrative purposes only and do not constitute financial advice. Always do your due diligence and consider your situation – and the help of a licensed financial professional – when making investment decisions.
If you don’t yet have industry professionals handling your portfolio, we can help! Check out Financial Professional’s investment marketplace, where we partner with some of the best in the business to help find the right investment for you.
The wash sale rule disallows investors from claiming a capital loss on a transaction that results in a loss under two scenarios:
When you purchase an investment either 30 days prior to or after the sale resulting in a loss, the loss is a “wash.” This means that you cannot claim the loss as a deduction from your income.
Furthermore, purchasing options for the investment can also subject you to the rule.
What purpose does this rule serve?
The IRS doesn’t want investors purchasing and selling investments solely for the sake of claiming a loss on their taxes. In other words, the government doesn’t want you to game the system.
So, what happens to the loss?
The amount of the loss is actually “capitalized”, meaning it can be added to the cost basis of the underlying security. However, you have to make sure you account for that yourself by keeping good records.
To make the concept clear, let’s go over an example.
Let’s say that you purchase 50 shares of Acme Inc at $20 on March 1st. Let’s also assume that you end up selling those shares at $15 (a $5 loss) on March 20th.
Because the purchase occurred less than 30 days prior to the sale resulting in a loss, the capital loss would be a wash.
Let’s look at another example.
Assume you bought 10 shares of Industrial Inc at $100 last year. The company has not performed well. The shares ended up dropping to $75. You decide to sell your shares at a $25 loss on January 1. Some positive news comes about Industrial Inc and the shares jump in price to $100 again. You decide to purchase the shares at $100 on January 15th.
Because you repurchased the shares within 30 days of the sale that saw a loss, you would be prohibited from claiming the original loss.
You want to avoid being subject to the wash sale rule as much as possible.
The best way of doing so is to keep track of either the original purchase date or the repurchase date as it relates to the date of the sale of the security. Once the 30-day period on either side of the sale has been satisfied, you can proceed without having to worry about the loss being considered a wash.
If you absolutely want to remain invested throughout the 30-day waiting period, you could consider holding a mutual fund or ETF (exchange-traded fund) that has similar characteristics to the initial holding.
For example, if you sold shares of an energy company, you could hold an energy ETF throughout the 30-day waiting period. Once the 30-day period is up, you could repurchase the shares of the energy company if you really wanted to.
Keep in mind, that there is nothing illegal about a sale resulting in a wash; you just can’t claim the loss as a deduction from your income.
What if, however, you repurchase the investment in an IRA? The wash rule can still apply. Even worse: it’s on you to claim the fact that the wash rule should apply. The cost basis will not adjust on the position in your IRA, either.
Losses are a natural part of investing, especially if you invest in equities. Smart investors and financial advisors know how to leverage the tax code to bring some positive to a negative situation, aka losing money in your portfolio.
Tax loss harvesting can be a powerful tool that can be leveraged to reduce your ordinary income. However, it must be done with a proper understanding of the tax code.
Performing a wash sale can completely cancel out the benefit of the capital loss deduction.
Prior to selling an investment, ask yourself, “Does this transaction subject me to the wash sale rule?”. If so, you may want to consider waiting the 30-day period out. The old adage “don’t let the tax tail wag the investment dog” also can apply here. This is why context and strategy are crucial.
As it relates to strategy, one of the benefits of “buy and hold” investing is that you are much less likely to be subject to the wash rule, as long as you don’t sell the investment at a loss and repurchase it within 30 days.
As always, keep your personal circumstances and financial goals in mind any time that you are making any sort of financial decision.
If you have questions on the wash sale rule? Let us know!
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