Some investors looking to claim portfolio losses on their taxes may be unaware of the wash sale rule. To find out what a wash sale is and how to comply with the rule, Bottom Line Personal talked to Maryann Reyes, principal with advisory firm WithumSmith+Brown.
Offsetting Losses
Understanding a wash sale requires familiarity with “tax-loss harvesting”—a technique whereby an investor can offset capital gains taxes owed on one stock’s gains by selling an underperforming stock and deducting the loss. Example: You did so well selling Stock A that you’re going to owe $60 in capital gains. But you’re down $40 on your investment in Stock B. If you sell both stocks, you can deduct the $40 from the $60 to reduce your tax exposure down to $20.
What Is a Wash Sale in Stocks?
Now let’s imagine that 10 days after you sell Stock B, it begins to recover, though its price is still low. Wouldn’t it be nice to buy back your position and make money on the stock and get the tax break?
Unfortunately, the IRS doesn’t allow this. Any purchase of a stock or of a “substantially identical” stock either 30 days before or 30 days after you’ve sold it for tax loss harvesting is considered a wash sale.
Note: This rule applies not only to straight stocks but also to exchange-traded funds (ETFs) and mutual funds. A substantially identical ETF could be one that you would invest in the same index as the one you sold.
What If You’re in Violation of the Wash Sale Rule?
There are no fines or penalties associated with wash sales. The IRS simply won’t allow you to claim the loss on this year’s taxes and will add it to the basis of the replacement shares you’ve purchased in violation of the rule. Example: You buy 10 shares of XYZ Stock at $10 per share ($100). The shares’ value drops to $6 per share. You sell your 10 shares for $60—a $40 loss. The stock climbs back up two weeks later to $7 a share, so you repurchase 10 shares for $70. Down the road when you go to sell your shares, it will be as if you paid $110 per share (the $40 loss plus the $70 paid), reducing capital gains at that time.
Caution: The wash sale rule applies across all of your portfolios. You could accidentally trigger the rule if you forgot that you owned a given stock in both your IRA and a separate investment portfolio. The same thing could happen if you sold some shares of a stock, left the others in place and reinvested their dividends.
The wash sale rule also applies to spouses, so it’s important to make sure that one spouse isn’t buying a security right after the other spouse has sold it for tax loss harvesting.
Cryptocurrencies currently are exempt from the rule but that could soon change.
