Robinhood, a popular platform for trading stocks and cryptocurrencies, has drawn millions of retail investors because it doesn’t charge a trading fee and investors can access a variety of blue-chip or penny cryptos and stocks. You can also access credit if you like margin trading. But when using Robinhood, you need to be aware of wash sale rules and what loss deductions for tax purposes aren't allowed.
As competition in the commission-free online brokerage space has intensified, even pioneers like Robinhood are seeking new ways to stand out. The broker has been adding more features to attract investors to its platform, including a crypto wallet and the ability to purchase pre-IPO stock. While it’s easy to get started trading stocks and cryptos on Robinhood, it helps to watch for potential tax mistakes that could cost you. Knowing the wash sale rule is particularly important.
What's the wash sale rule, and how does it affect you?
People don’t like taxes, and the IRS knows it. But its business is to collect taxes from people and businesses to fund the government, which is seeking more money for programs such as upgrading infrastructure and combating climate change.
To ensure that everyone shoulders their fair share of funding the government, the IRS must seal tax loopholes. Its wash sale rule is to prevent people from using certain investment losses to claim tax deductions.
If you sell a security like a stock for a loss and then go back and repurchase the same stock or a similar one almost immediately, the IRS considers that a wash sale. As a result, you would be subject to the wash sale rule. And that means you can’t use that investment loss to offset your capital gains so as to reduce your tax exposure.
To avoid running afoul of the wash sale rule, you need to wait at least 30 days to repurchase stock you sold off for a loss. The rule also applies to securities such as bonds and ETFs.
Understanding wash sale losses being disallowed on Robinhood
There's a story of Robinhood trader who made a profit of $45,000 trading on the platform in a year but ended up with an $800,000 tax bill. The novice investor had repeatedly breached the wash sale rule.
Instead of waiting 30 days to repurchase a security recently sold, the investor kept trading in and out of securities at will. The investor apparently knew that capital losses could be used to offset capital gains but got the timing wrong. As a result, the IRS disallowed the Robinhood trader from claiming tax deductions tied to the capital losses.
However, the wash sale rule doesn’t erase your capital losses, but defers them instead. If a wash sale occurs, the loss gets added to the cost basis of the new purchase. As a result, you can get an indirect tax benefit when you sell in the future. For example, the higher basis cost for the new purchase would reduce your future capital gain and result in a lower tax exposure.
Is crypto subject to the wash sale rule?
Robinhood offers its users a handful of cryptocurrencies to trade, and its community wants the platform to list more.
When it comes to taxes, crypto traders have an advantage—though that may soon not be the case. While the IRS treats stocks, bonds, and ETFs as securities, it considers cryptocurrency property. As a result, crypto trades aren’t subject to the wash sale rule, and investors are taking advantage of that to minimize their tax exposure. They’re "loss-harvesting," applying losses from crypto trades to offset profits from stocks and other securities.
Other tax saving maneuvers if loss-harvesting is disallowed
While loss-harvesting is a popular strategy to reduce tax exposure, there are several other ways you could reduce your tax bill. If you have capital gains, donating some of it to a charity would allow you to claim a tax deduction. Sending more money to your retirement savings account or spending on medical bills would also reduce your taxable income.
If you run a business, you could use the capital gains to pay business expenses such as rent and supplies in advance. That way, you would reduce your taxable income and face a lower tax bill.