How to Avoid Violating Wash Sale Rules When Realizing Tax Losses

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How to Avoid Violating Wash Sale Rules When Realizing Tax Losses

Tax-loss selling is an investing technique that may assist an individual in lowering their taxable income for a certain tax year. Tax-loss selling is selling a securities that has incurred a capital loss in order to record it as a capital loss when paying annual income taxes, lowering or eliminating any capital gain generated by other investments.

You must liquidate the investment throughout the tax year in order to effectively realize the loss for tax reasons. Any unrealized investment loss cannot be deducted from your income taxes.

An investor may elect to replace a security with a comparable security in order to maintain a constant, optimum asset allocation and achieve their targeted returns. If you employ this technique, you must be careful not to mistakenly trigger a wash sell in your investment account.

Key Takeaways

  • Wash-sale regulations restrict investors from selling a share at a loss, then repurchasing the same investment and reaping the tax losses via a decrease in capital gains taxes.
  • Tax-loss selling is an investing technique that may assist an investor in lowering their taxable income for a certain tax year; investors may be allowed to claim up to $3,000 in capital losses every year to offset their taxable income (if they are married filing jointly).
  • Selling an investment and buying another with equivalent exposure is a frequent approach for avoiding the wash-sale rule.

What Is a Wash Sale?

A wash sale happens when you sell or trade shares or assets at a loss and then buy the same—or a “substantially identical”—investment within 30 days of the sale (either before or after). The wash-sale rule is a policy enacted by the Internal Revenue Service (IRS) to prohibit taxpayers from claiming fictitious losses in order to maximize their tax advantages.

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When you make a wash sell in a non-qualified account, the loss is applied to the cost basis of the new, “substantially similar” investment you bought. If you keep trading the same investment, the loss is carried forward with each transaction until the position is entirely liquidated after more than 30 days.

The same requirements apply if the spouse of the person selling the asset, or a corporation controlled by that person, acquires the same or substantially identical securities within 30 days.

Furthermore, your holding time for the new stock or securities (for determining whether the investment will result in a short- or long-term capital gain) includes the holding period for the previously sold stock or securities.

Investments Subject to Wash Sale Rules

Stocks or securities in non-qualified brokerage accounts and individual retirement accounts are subject to the wash-sale regulation (IRAs).The wash-sale rule would also be violated if you sold options at a loss and then repurchased identical options within 30 days.

In IRS Publication 550, headed “Investment Income and Expenses,” the IRS sets criteria on what constitutes a “substantially similar” investment and so may result in a wash-sale violation (Including Capital Gains and Losses).A substantially comparable investment may contain both new and old securities issued by a reorganized firm, as well as convertible securities and ordinary stock issued by the same company.

When an investor has several investment accounts, wash-sale regulations apply to the investor as a whole rather than to each individual account. Brokers must monitor and report any sales of the same CUSIP number in the same non-qualified account, according to the IRS. Investors, on the other hand, are responsible for monitoring and reporting any sales that occur in any other accounts they manage, including any accounts owned by their spouse.

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Offset Capital Gains Through Tax-Loss Selling

While some investors focus on tax-loss selling at the end of the calendar year, you may employ this approach throughout the year to capture tax losses by rebalancing or replacing holdings in your portfolio. Capital losses are initially used to offset taxable capital gains. Following that, an individual filer or married couple filing jointly may use up to $3,000 each year to offset additional taxable income (married filing separately can use up to $1,500).

For example, if an investor achieves $5,500 in long-term losses throughout the year, they may use $2,000 of those losses to balance taxes on other capital gains and $3,000 to offset taxes on regular income when they submit their income taxes. If this investor’s long-term capital gains tax rate is 20% (based on their income) and their effective federal income tax rate is 25%, the $5,500 loss may be lowered by $1,150 employing this technique.

The investor may also be entitled for a discount in state taxes, depending on where they reside. The remaining capital losses in the amount of $500 may be carried forward to future tax years. Unfortunately, losses cannot be passed on after death.

Strategies for Avoiding Wash Sales

There are ways to prevent wash sales while still benefiting from taxable profits and losses. If you hold an individual stock that has suffered a loss, you may prevent a wash sale by purchasing more stock and then waiting 31 days to sell the shares that have suffered a loss. One possible disadvantage of this method is that it might raise your market exposure to a certain industry, possibly increasing your risk.

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In a similar case, an investor may opt to sell the holding, realize the loss, and then immediately purchase a comparable investment that meets their investing objectives or portfolio allocation. For example, an investor may elect to sell The Coca-Cola Company (KO) shares and then immediately make a comparable investment in PepsiCo, Inc. (PEP).

Similarly, an investor may opt to sell their Vanguard 500 Index Fund (VFIAX) shares and replace them with Vanguard Total Stock Market ETF shares (VTI).

Corrected: January 20, 2022. In an earlier version of this article, the offset amount for individual taxpayers was wrongly stated.

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