Brokers are only reporting potential wash sales, not final wash sales

During our March 20 Webinar, we realized that perhaps in accordance with 1099-B rules, many brokers only seem to report “initial wash sale loss deferrals” (potential wash sales), rather than final “wash sale losses.”

Brokers' 1099-Bs list individual wash sale losses and then total wash sale loss amounts, often in the hundreds of thousands, or even millions. That's simply impossible in most cases, because many traders have far less money in their accounts to begin with. Final wash sales can't be higher than the account size. We now have a better understanding of how this problem arose.

Potential wash sales are only half the story. Trade-accounting software like TradeLog follows a wash sale condition from beginning to end. Often, when a wash sale loss is triggered, it goes away when the trader sells replacement positions at a large enough gain to absorb the deferred wash sale losses. Wash sale losses are added to cost basis on the replacement position. Another way to make wash sale losses go away is to “break the chain” on a string of wash sale losses, by not buying back a substantially identical position for 30 days before, or after.

Here's an example: A trader day trades X stock every trading day of the year and loses money on most of those trades. He stops trading on Dec. 15 and does not trade again until Jan. 25. The trader triggered wash sale loss conditions on most days of the year. This trader broke the chain of wash sales on Dec. 15 by selling all his positions, and not buying any of them back until after 30 days. The result is zero wash sales for 2011 taxes. Unfortunately, his broker will probably report every one of the potential wash sale losses and total them up, too. A trader cannot use this 1099-B wash sale information as it's only half the story on wash sales.