Taxpayers’ ability to deduct investment losses against capital gains may motivate many to incur losses on their stocks and securities at the conclusion of a tax year. When making changes to their portfolios, taxpayers must be cautious not to engage in wash sales, otherwise their deductions may be denied.
Wash Sales: It’s All About Staying Clean
If an investor seeks to sell an asset and suffer a loss in order to deduct it against capital gains, that investor must ensure that they are not adding a substantially comparable position within 30 days before or after the sale.
According to the Securities and Exchange Commission, if a taxpayer purchases an identical stock or investment within 30 days of the transaction that results in the loss, the loss is not deductible. Furthermore, if the taxpayer purchases a contract or option on an identical security within the same time period, their loss will not be deductible.
According to IRS Publication 550, in order to avoid triggering the wash sale, an investor must also avoid purchasing a substantially comparable investment inside their Traditional or Roth IRA. This is significant because, in general, losses inside an IRA are restricted to the IRA and, unless under exceptional circumstances, cannot be deducted against capital gains. Investors who understand this may assume that wash sale restrictions do not apply if substantially comparable stock is sold from a non-IRA account and repurchased inside an IRA, but this is wrong.
Other unusual conditions may also trigger the wash sale rule. If the investor’s spouse or a company under the investor’s control acquires a substantially similar investment within 30 days after the transaction, the wash sale may occur. A purchase is not always required to deny a loss deduction. Employees who get bonus shares of company stock may be unable to deduct losses if they earn further incentives within 30 days of the sale.
Some mutual fund acquisitions may potentially be in violation of the wash sale restrictions. Even though the fund family isn’t the same, funds that are designed after the same index may be regarded substantially equivalent.
When a Deduction Is Disallowed
According to IRS Publication 550, a disallowed loss will be applied to the cost basis of the new security. This will effectively counteract future profits and may even result in losses if the investment is sold in the future. Furthermore, for capital gains purposes, the holding term for the new security will include the holding period for the security sold.
The Concept of Substantial Identicalness
If you want to avoid the wash sale rule, you must first grasp what the IRS considers to be substantially comparable. Publication 550 provides an example of a company that reorganizes and has a successor. In such instance, both organizations’ securities may be regarded essentially equivalent. Another example is preferred stock that may be converted into ordinary stock.
Working Around the Wash Sale Rule
There are a few workarounds that may allow you to keep all or part of your deduction while acquiring basically comparable stocks. The first is that a partial deduction is available if additional stock is sold and then repurchased within 61 days after the transaction. For example, if you own 1,000 shares of XYZ and sell all of them at a loss before repurchasing 200 shares, you may still be able to deduct the loss on the net 800 shares sold. Because the disallowed loss and the other 200 shares will be added to the cost basis of the newly bought 200 shares, the remainder of your loss is merely deferred.
Another option is to simply acquire essentially similar shares outside of the 30-day intervals before or after the sale, resulting in losses.
The Bottom Line
The wash sale rule may result in the loss of a valuable deduction. As a result, it’s critical that you understand what constitutes “essentially similar” and follow the aforementioned guidelines to get around the wash sale prohibition.
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