It isn't a great idea to try to trick the IRS to reduce your taxes because the consequences can be severe. As a result, investors should know how to avoid breaking wash sale rules.
Breaking down a wash sale in stocks
In stocks, a wash sale happens when you sell a stock at a loss and buy it back again almost immediately. Some canny traders use the wash sale strategy to claim tax benefits. As a result, the IRS came up with rules to close the tax loophole.
A wash sale would work this way — you purchase 100 shares of a stock at $10 per share for an investment of $1,000. At some point, the stock starts to drop. You decide to sell the stock, but now it’s going for $8 per share instead of the $10 you paid for it, which results in a $200 loss.
Since you still want to own the stock, you return to the market within 30 days of the sale and buy it again. The transaction would be regarded as a wash sale. You can’t apply the $200 loss to reduce your taxable income in the current tax year.
In addition to losing the ability to apply the tax benefit immediately, the cost basis of your new purchase will be bumped up. Say you made a replacement purchase of 100 shares like before but now at a price of $5 per share for an investment of $500. The $200 from the wash sale will be added to the cost of your replacement purchase and push the basis cost up to $700.
How a wash sale impacts an investor
The obvious consequence of a wash sale is that it denies you the ability to apply the loss from a losing investment to reduce your taxes immediately. You don’t really lose money in a wash sale. Adding the loss to the cost basis of the replacement purchase means that the loss is merely delayed until you sell the stock.
However, you should be careful not to trigger a wash sale in a retirement account because the loss can't be reclaimed in the future. The ugly part of the wash sale rules is that they can impact active traders or investors who have no intention of harvesting losses. You can overcome this by keeping your trading and retirement savings accounts separate.
Wash sales are reported to the IRS
The IRS requires brokers to track and report wash sales on the accounts they host. Also, the IRS rules make investors responsible for tracking and reporting wash sales in all their accounts.
How to avoid violating wash sale rules in stocks
You can avoid violating wash sale rules in several ways. First, you should allow at least 30 days to pass after selling a stock before purchasing it again. The other option is to purchase a similar stock instead of the same stock. For example, if you sold Groupon stock, you could use the proceeds to purchase eBay, Shopify, or Amazon stock because they are in the same e-commerce industry. Similarly, you could replace Nikola stock with Tesla or NIO stock as they are all in the electric vehicle industry.