Capital gains can really eat away at your tax return. This is especially true for short-term trades that you held for less than a year, which are taxed at a higher rate than long-term gains. Capital losses up to $3,000 can balance out those gains, and many taxpayers might be tempted to harvest their losses in clever ways. However, the IRS has a regulation called the wash-sale rule to discourage people from taking advantage of this.
How do wash-sale rules disallow certain losses? How could the rules impact your taxes?
Wash sale, explained
According to the SEC, a wash sale "occurs when you sell or trade securities at a loss and within 30 days you buy substantially identical securities, acquire substantially identical securities in a fully taxable trade, or acquire a contract or option to buy substantially identical securities."
Let's put this in layman's terms. Basically, if you sell a security at a loss and then rebuy the same security within 30 days, it's a wash sale.
How the wash-sale rule impacts your taxes
The IRS doesn't allow wash sales to count as capital losses on your taxes. Otherwise, it would be a frequently used loophole to build up losses that balance out your gains, which would help you avoid paying higher taxes.
Wash sales aren't inherently disallowed. However, using them as a tax deduction is. While losses from wash sales aren't allowed, investors can still be taxed on gains.
Information regarding wash-sale rules can be found in IRS Publication 550, which discusses capital gains and losses.
How to avoid wash sales
Some people who sell a security only to buy a substantially identical one within 30 days are outright attempting a wash sale. However, other investors might not realize that losses relating to wash sales aren't deductible or that there's a thing called a wash sale at all. Knowing how to avoid wash sales starts with knowing what they are.
From there, investors can make sure:
- They aren't reinvesting in a reorganized company that counts as "substantially identical" in the eyes of the IRS.
- They aren't reinvesting in preferred stock after selling common stock.
- Their spouse or a business they control doesn't buy the same stock within the applicable time period.
If you conduct a wash sale and eventually sell the new shares at a loss, you will get the tax deduction benefits at that point (as long as you aren't performing another wash sale). Make sure you report any wash sales to avoid tax penalties. You can do this by self-reporting them in Form 8949 or using the sale of stocks section in your online tax program.
How to get around the wash-sale rule
While wash sales aren't deductible, some forms of tax-loss harvesting are allowed. You can:
- Sell a stock and repurchase it 31 days (or more) later, since the wash-sale rule only applies for up to 30 calendar days.
- Add to your holding and, after 31 days, sell off some shares at the higher average cost basis (the price you purchased the securities at).
- Reinvest in a stock that doesn't apply as "substantially identical" in the eyes of the IRS. This is a stock swap.
Tax-loss harvesting is helpful as long as it doesn't apply as a wash sale, but it's worth noting that the average investor won't see drastic improvements on their taxes. Higher-earning individuals in higher tax brackets are more likely to reap the rewards.
Also, those who get classified as a trader with the SEC can avoid the wash-sale rule (as well as the $3,000 cap on capital losses), but that won't apply to most retail investors.