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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 …


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