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Wash-Sale Rule

Definition

A wash sale is a sale of a security at a loss and repurchase of the same or substantially identical security shortly before or after. Wash sale regulations protect against an investor who holds an unrealized loss and wishes to make it claimable as a tax deduction within the current tax year. The security is then repurchased in the hope that it will recover its previous value, which would only become taxable in some future tax year. A wash sale can take place at any time during the year. In the UK, a similar practice which specifically takes place at the end of a calendar year is known as bed and breakfasting. In a bed-and-breakfasting transaction, a position is sold on the last trading day of the year to establish a tax loss. The same position is then repurchased early on the first session of the new trading year, to restore the position. The term, therefore, derives its name from the late sale and early morning repurchase.

What is the 'Wash-Sale Rule'

An Internal Revenue Service (IRS) rule that prohibits a taxpayer from claiming a loss on the sale or trade of a security in a wash sale. The rule defines a wash sale as one that occurs when an individual sells or trades a security at a loss, and within 30 days before or after this sale, buys a “substantially identical” stock or security, or acquires a contract or option to do so. A wash sale also results if an individual sells a security, and the spouse or a company controlled by the individual buys a substantially equivalent security.
 

Explaining 'Wash-Sale Rule'

Stocks or securities of one company are generally not considered substantially identical by the IRS to those of another. As well, bonds and preferred stock of a company are also ordinarily not considered substantially identical to the company’s common stock. However, there may be circumstances in which preferred stock, for example, may be considered substantially identical to the common stock. This would be the case if the preferred stock is convertible into common stock without any restriction, has the same voting rights as the common stock, and trades at a price close to the conversion ratio.
 
If the loss is disallowed by the IRS because of the wash sale rule, the taxpayer has to add the loss to the cost of the new stock, which becomes the cost basis for the new stock. For example, consider the case of an investor who purchased 100 shares of Microsoft for $33, sold the shares at $30, and within 30 days bought 100 shares at $32. In this case, while the loss of $300 would be disallowed by the IRS because of the wash sale rule, it can be added to the $3,200 cost of the new purchase. The new cost basis therefore becomes $3,500 for the 100 shares that were purchased the second time, or $35 per share.
 


Further Reading


New twists on an old plot: investors look to avoid the wash sale rule by harvesting tax losses with exchange-traded funds
heinonline.org [PDF]
… David M. Schizer, Financial Instruments: Special Rules, [2010] 1 Tax Mgmt … repurchase a share of Corporation Y within thirty days in order to maintain his economic position.57 … take advantage of loopholes in the wash-sale rule without running afoul of it."59 Registered with the …

Optimal portfolio choice with wash sale constraintsOptimal portfolio choice with wash sale constraints
www.sciencedirect.com [PDF]
… David M. Schizer, Financial Instruments: Special Rules, [2010] 1 Tax Mgmt … repurchase a share of Corporation Y within thirty days in order to maintain his economic position.57 … take advantage of loopholes in the wash-sale rule without running afoul of it."59 Registered with the …

Tax-loss trading and wash salesTax-loss trading and wash sales
www.sciencedirect.com [PDF]
… David M. Schizer, Financial Instruments: Special Rules, [2010] 1 Tax Mgmt … repurchase a share of Corporation Y within thirty days in order to maintain his economic position.57 … take advantage of loopholes in the wash-sale rule without running afoul of it."59 Registered with the …

Part IVA and Wash Sale Arrangements-Will It All Become Clear in the WashPart IVA and Wash Sale Arrangements-Will It All Become Clear in the Wash
heinonline.org [PDF]
… David M. Schizer, Financial Instruments: Special Rules, [2010] 1 Tax Mgmt … repurchase a share of Corporation Y within thirty days in order to maintain his economic position.57 … take advantage of loopholes in the wash-sale rule without running afoul of it."59 Registered with the …

An Empirical Evaluation of Tax-Loss-Harvesting AlphaAn Empirical Evaluation of Tax-Loss-Harvesting Alpha
www.tandfonline.com [PDF]
… David M. Schizer, Financial Instruments: Special Rules, [2010] 1 Tax Mgmt … repurchase a share of Corporation Y within thirty days in order to maintain his economic position.57 … take advantage of loopholes in the wash-sale rule without running afoul of it."59 Registered with the …

A stock index mutual fund without net capital gains realizationsA stock index mutual fund without net capital gains realizations
www.nber.org [PDF]
… David M. Schizer, Financial Instruments: Special Rules, [2010] 1 Tax Mgmt … repurchase a share of Corporation Y within thirty days in order to maintain his economic position.57 … take advantage of loopholes in the wash-sale rule without running afoul of it."59 Registered with the …

The optimal bankruptcy rule in a trading economy using fiat moneyThe optimal bankruptcy rule in a trading economy using fiat money
link.springer.com [PDF]
… David M. Schizer, Financial Instruments: Special Rules, [2010] 1 Tax Mgmt … repurchase a share of Corporation Y within thirty days in order to maintain his economic position.57 … take advantage of loopholes in the wash-sale rule without running afoul of it."59 Registered with the …

Dirty Linen: Airing out the Wash Sale RulesDirty Linen: Airing out the Wash Sale Rules
heinonline.org [PDF]
… David M. Schizer, Financial Instruments: Special Rules, [2010] 1 Tax Mgmt … repurchase a share of Corporation Y within thirty days in order to maintain his economic position.57 … take advantage of loopholes in the wash-sale rule without running afoul of it."59 Registered with the …



Q&A About Wash-Sale Rule


Can we buy back our shares if they have appreciated in value ?

Yes , you can buy back your shares if they have appreciated in value .

Who are considered as two different taxpayers under Wash Sale Rule ?

Two individuals who file separate returns are considered as two different taxpayers under Wash Sale Rule .

Is it necessary that both purchases must be made on same day ?

No , it is not necessary that both purchases must be made on same day .

What does Rev. Rul 28-5 discuss about Wash Sale Rule?

It discusses how to determine whether there has been an abuse of this provision when two different taxpayers sell substantially identical property at a loss during any period of 12 months and purchase substantially identical property which has not been held more than 30 days during such period for their own account within such period (or within 30 days thereafter).

Which publication discusses the wash-sale rule?

Publication 55 – Investment Income and Expenses discusses the wash-sale rule in detail.

What is the purpose of the wash-sale rule?

The intent of the wash-sale rule is to prevent investors from abusing wash sales so as to maximize tax benefits.

Can we take advantage of this provision even if we do not hold our shares for more than one year ?

Yes , you can take advantage of this provision even if you do not hold your shares for more

Are stocks of one company considered substantially identical by the IRS to those of another?

Stocks of one company are generally not considered substantially identical by the IRS to those of another. As well, bonds and preferred stock of a company are also ordinarily not considered substantially identical to the common stock. However there may be circumstances in which preferred stock for example may be considered substantially identical to the common stock. This would be the case if the preferred stock is convertible into common stock without any restriction, has the same voting rights as the common stock and trades at a price close to its conversion ratio.

How does a wash sale occur?

A stock or security is sold at a loss, and within 30 days before or after that sale, another identical stock or security is purchased.

When was Rev. Rul. 28-5 issued by IRS?

Rev. Rul. 28-5 was issued in 1928 by IRS (Internal Revenue Service).

If an investor sold Microsoft for 33 dollars per share then bought it again within three days for 32 dollars per share what would happen?

The investor could claim that they lost money on their investment because they bought it back for less than they sold it but because this was done within three days after selling it then this transaction would be disallowed by the IRS because it violated their "wash-sale rule". The investor would have had no choice but add their loss onto their cost basis for Microsoft shares which means that instead of having lost money on their investment they actually made money on it even though they didnt realize that until years later when reviewing past transactions with tax professionals who pointed out that adding your losses onto your cost basis can sometimes make you look like you made more profit than you really did. In this case however since we know exactly how much profit was made (or in this case how much loss) we can subtract that amount from our original purchase price and see how much profit was actually made on our initial investment in Microsoft shares (in other words

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