The wash sale rule and how it affects you

What is the wash sale rule?

A wash sale occurs when you trade or sell securities at a loss. Then, within 30 days either before the sale or after it, you purchase securities that are substantially identical, purchase securities that are substantially identical in a taxable trade, or purchase an option to buy or a contract to buy securities that are substantially identical to the ones that were sold at a loss.

When you complete a wash sale, the Internal Revenue Service prohibits you from deducting the losses that you sustained related to it. This is because the IRS considers this to be an artificial loss for which you should not be able to derive tax benefits. Avoiding the wash sale rule is important for reducing your tax liability.

What is the holding period and why is it important?

The holding period for securities is how much time an investor holds an investment. In other words, it is the period of time between the date of the purchase and the date when the security is sold. This is the time frame that is scrutinized when looking to apply the wash sale rule.

The holding period begins to run on the day after a security is acquired. It continues until the day that it is sold or until you dispose of the security. The holding period is important because it is used to determine the tax implications of the disposal or the sale of the security.

Some people use tax loss harvesting to try to reduce the capital gains taxes that they might otherwise have to pay. Tax loss harvesting occurs when you sell securities that have experienced a loss, which can help to reduce the capital gains taxes that you would otherwise owe. If you do not hold your securities for a long enough period of time and subsequently repurchase them too quickly, you will not be able to benefit from tax loss harvesting because of the rules on wash sales.

When you hold securities for a longer period of time, the capital gains tax rate goes down on any profits that you might make. This is because lower capital gains tax rates apply for assets that are held for a year or longer. Conversely, if you sell a security at a loss too quickly, the wash sale rule might prevent you from deducting the losses on your taxes so that you do not benefit from an artificial loss.

Statistics on filing taxes

Nearly 54 million people prepare and file their own taxes each year, according to data from the IRS. Out of all of the tax returns that were filed, 92% were e-filed.

The tax filing statistics demonstrate that many people choose to file their taxes on their own without help from tax professionals. While software has made tax preparation easier, people might still make mistakes when it comes to understanding the IRS rules for capital gains, the wash sale rule, and how they can minimize their taxes.

Wash sale rule

This rule was created to prevent investors from trying to reduce their capital gains to avoid taxes through a basis adjustment. It was also created to keep people from claiming tax losses on investments that they continue to possess. It applies to sales within the wash sale period for stocks, securities, mutual fund shares, bonds, and some other types of investments.

A capital loss occurs when an investment or piece of real estate falls in value. The loss is not realized until the time when the asset sells for a price that is lower than the original purchase price. If your capital losses are greater than your capital gains, you can claim a tax deduction from the difference between the two. A capital loss deduction can offset your wages and your capital gains up to a specific amount through a basis adjustment. In some cases, you can defer a capital loss on an investment until later.

You are not allowed to deduct losses from a stock or security trade or sale unless you incurred the loss during the ordinary course of business as a dealer of the stock or security. The wash sale rule also applies if you sell a security or stock at a loss and your spouse or business subsequently buys the same stock or security during the 30-day period following the sale.

Wash sale and investments

The wash sale rule applies to mutual fund shares, bonds, stocks, options, and ETFs that are held in non-qualified brokerage accounts or IRAs. If a company is reorganized, the securities and stocks of the predecessor and successor corporations can be substantially identical.

The IRS considers preferred stock to be substantially identical to common stock if the preferred stock can be converted into common stock, has the same dividend restrictions, has the same voting rights, is unrestricted as to convertibility, and that trades at prices that are similar to the conversion ratio.

Normally, the securities or stocks of one corporation are not considered to be substantially identical to those of a different corporation. Preferred stock or bonds of a corporation are normally not considered to be substantially identical to the common stock of the same company.

If you do sell a security at a loss in your taxable account and subsequently buy the same security or one that is substantially identical in your IRA account, you would be permanently disallowed from claiming the capital loss instead of simply being able to defer it to a later date.

For options and futures contracts, the wash sale rule applies to losses from the trades or sales of options and contracts to sell or acquire stocks or securities. It does not apply to losses that you incur from trades or sales of commodity futures contracts or of foreign currencies.

For securities futures contracts to sell, the rule applies to losses that you incur from the termination, exchange, or sale of the futures contract to sell. They are generally treated in the same way as losses from the closing of a short sale.

For warrants, the rule applies if you sell your common stock at a loss and simultaneously by warrants for the common stock from the same corporation. Conversely, the rule applies if you sell warrants that you hold at a loss and simultaneously purchase common stock in the same company only if the warrants and stocks are considered to be substantially identical.

For residual interests in a real estate mortgage investment conduit or a REMIC, the wash sale rule applies to your sale of your residual interest in the REMIC if, starting from six months prior to the sale of our interest and ending six months afterwards, you acquire any new residual interest in a REMIC or any interest in a comparable, taxable mortgage pool.

When you purchase and then sell stocks or securities that are more or less substantially identical, you will need to determine which shares the rule applies to. You can do so by matching the shares that you purchase with an equal number of the shares that you sold. Match your shares in the same order that you bought them, starting with the first shares. The shares that are matched in this way are subject to the wash sale rule.

When you have capital losses and capital gains on the same day, the rule applies to the capital losses that you realize on one group of securities or stock. You will be unable to use those losses realized on that group to reduce any gains on an identical group that you sell on the same day, meaning the losses will not affect the cost basis of your investments.

For short sales, the wash sale rule applies if you sell or enter into another short sale of substantially identical securities or stocks during a time period that begins 30 days before the date that your short sale is completed and ending until 30 days afterward.

Adjusting cost basis

According to the IRS, if your loss was not permitted because of the wash sale rule, you can add it to the cost of the new securities or stocks that you purchase. It will become the new cost basis of your newly purchased stock or securities. If you do this, it puts off your deduction until you sell the new securities or stocks. For your new investment, the holding period will include the holding period for the securities or stocks that you sold.

When you add a wash sale loss to the cost basis of the replacement shares, your loss is deferred. A deduction can be allowed when you sell the replacement shares.

Reporting a wash sale

To comply with the IRS rules, you must report each wash sale that you complete on Schedule D of Form 8949. Even if your wash sale is not reported on Form 1099-B, you are not allowed to deduct the loss from the sale.

The wash sale rule applies to the investor and not to the accounts if you have multiple accounts. Brokers are mandated to track, and report wash sales of securities with the same CUSIP number that are in the same non-qualified account. Investors are also required to track and report any sales that happen in their other accounts over which they have control if the rule might apply. This includes both their own accounts and those of their spouses.

Avoiding a wash sale

The wash sale rule is a difficult part of the tax code, and it can eat away at your future retirement income. It is important for you to avoid wash sales wherever possible so that you can preserve the tax benefits of a capital loss. You can avoid it by simply waiting until the 61-day wash sale period is over before you purchase the same security or stock again.

In order to avoid the wash sale rule, you must outwait the wash sale period. You can then defer your capital loss to another year when it might be more beneficial to you. Another way to avoid the application of the rule is by purchasing securities that are similar but that are not substantially identical to the securities or stocks that you sold.

While internet resources and tax programs have assisted in self-tax preparation, it is still common for people to make mistakes when it comes to understanding the IRS rules for how to minimize taxes. If you are unclear as to the specifics of wash sales, it is always best to seek the help of a professional.

Start investing for free with M1 Finance

You are able to save more when you choose M1 Finance. We offer award-winning investment tools that help your money to grow automatically while minimizing the tax burden that you might face. It uses built-in tax efficiency through its tax minimization strategies to help you to reduce the amount that you might owe on your taxes automatically.

M1 Finance allows investors at all levels to invest without paying any management fees or commissions. This fee-free approach allows your money to work even harder as you strive to accomplish your financial objectives. When you open an account with us today, you are able to customize your portfolio in a way that meets your goals and needs. Alternatively, you can choose a portfolio that has been created by expert financial professionals to meet different levels of risk tolerance, time to invest, and financial goals.

M1 Finance is a firm that offers investors the benefits of a traditional brokerage combined with the latest digital technology and automation. This helps investors of all levels to access and understand investing. The platform uses automated reinvestment and dynamic rebalancing to help you build wealth effortlessly. You can access the platform via your laptop or mobile device from anywhere and at any time. This can save you time while also helping your portfolio to continue working automatically to reach your goals.

Tax and Legal Advice Disclaimer. M1 Finance and its affiliates do not provide tax, legal or accounting advice. This material has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for, tax, legal or accounting advice.