What Investors need to Know About the Wash-Sale for Tax Season

With tax season upon us, you’ll want to understand how tax rules apply to your trades.

Pay attention to the wash-sale rule, which applies to trades you’ve sold for a loss, then replaced with the same or “substantially identical” security within 30 days of the sale.

Let’s see how this works. 

What is the Wash-Sale Rule?

The Internal Revenue Service (IRS) designed the wash-sale rule to stop investors from selling a stock or other security at a loss to nab a tax benefit while buying back the same security soon after. 

Even if you don’t intend to break the rule, you still can’t take the tax loss on your return for the current year.  The IRS requires you to add the loss to the replacement stock’s cost basis. That’s not all — the period of time you held the original stock is added to that of the new stock. 

If you use an automated investing strategy, such as dividend reinvestment, you may inadvertently trigger the wash-sale rule and miss out on tax benefits.

You don’t want to incur the tax penalty of the wash-sale rule. Here is a deeper look at how the rule works. 

Accounting Security Challenges

Today’s brokerages comply with Congressionally-mandated cost-basis reporting rules. Phase-in of these rules began in 2011. 

You’ll want to understand the rule thoroughly to steer clear of mistakes. 

The IRA wash-sale rule applies to various securities, including:

• Stocks
• Bonds
• Mutual funds
• ETFs
• Options

You can’t sell an investment for a loss in a taxable account and then purchase the same security in an Individual Retirement Account or a different taxable account. Also, the IRS prohibits these transactions in accounts you hold at different brokerages. 

For example, you can’t sell a stock for a loss at Fidelity and purchase it within 30 days at Schwab.

Also, the wash-sale rule applies to your spouse’s accounts. This means you can’t sell a security in your own account and buy it back in your spouse’s account within that 30-day period. 

How Does a Wash-Sale Rule Work?

Here are the mechanics of a wash sale:

• You sell a security for a loss.
• Within 30 days or less, either before or after you sell, you
  • Purchase another security that is substantially identical.
  • Enter into an options contract for a substantially identical security.
  • Purchase a substantially identical security in a qualified retirement account.

The purpose of the wash-sale rule is to prevent investors and traders from finding workarounds to capital-gains taxes. The IRS enforces the wash-sale rule by adding the amount of a loss to the price of a new security you purchase. 

Say you buy a share of stock at $100, but the price falls, and you sell it for $80. Your capital gains tax loss is $20. 

But imagine, after you sell, you immediately turn around and buy the same stock for $90. In that case, the IRS considers $110 as your stock price. You get that by adding the capital gains loss to the price of your new purchase. 

Can I Avoid a Wash Sale?

If you sell a stock at a loss but still want to invest in that same industry or sector, can you avoid a wash sale?

You absolutely can avoid a wash sale by substituting an exchange-traded fund (ETF) or mutual fund that tracks the same industry or sector. 

You’ll find ETFs especially well suited to avoiding a wash-sale rule if you sell shares for a loss. Many ETFs target a specific industry or sector, giving you exposure to the same asset class as the security you sold. Because ETFs track a broad basket of stocks, you’ll own enough securities to satisfy IRS regulations regarding a substantially identical security. 

Be aware: Switching one ETF or mutual fund for another may trigger the substantially identical security rule. For example, if you sell the SPDR S&P 500 ETF (SPY) at a loss and substitute it with the iShares Core S&P 500 ETF (IVV) you’re simply swapping one S&P 500 ETF for another. 

If the IRS determines you’ve violated the wash-sale rule, you’ll likely incur a heftier tax burden than you expected. If you’re not sure whether a sale will trigger the rule, ask your tax professional or financial advisor. 

Rules for 1099-B Forms

Your broker will issue a Form 1099-B that includes cost-basis information. You’ll need this document to do your taxes, but it doesn’t provide all the information you’ll need.

Brokerages send Form 1099-B to you and the IRS. Your broker indicates any trade losses not allowed due to the wash-sale rule. 

Form 1099-B shows you the short- and long-term proceeds from your trades, along with the cost basis. When you prepare your taxes, you’ll report each transaction on a separate line IRS Form 8949.

If you hold accounts at multiple brokers, you’ll need the 1099-B from each to do your taxes. 

Tax Optimization for Wash Sales

You can avoid wash sales and still enjoy the tax advantages of offsetting taxable gains with investment losses. 

Here’s a strategy for selling a stock with a loss without setting in motion the wash-sale rule. 

Say you own an individual stock with a loss. You can purchase additional shares now but wait 31 days before selling the shares with a loss. That strategy comes with some risk: It increases your stake in a particular security, which may add to portfolio risk. 

Another strategy is selling right away if you have a loss, and buy a similar investment that won’t activate the wash-sale rule. For example, say you sell United Airlines (NASDAQ: UAL) at a loss, but you still like the prospects for the airline industry. You can buy shares of Southwest Airlines (NYSE: LUV), which would not be a wash sale. 

Wash Sales and Your Stocks

The wash-sale rule applies to your nonqualified, taxable accounts as well as your qualified retirement accounts. Whether you hold single stocks, mutual funds or ETFs, or whether you trade options, the rule applies. 

Trades of stocks and funds held in your IRA or another qualified account won’t trigger a wash sale, as the IRS doesn’t track gains and losses within these accounts. 

However, you’ll still need to proceed with caution. Don’t sell a stock with a loss in your taxable account, then purchase it in your IRA within 30 days. That would count as a wash sale. 

Another thing to watch for: If you sell shares with a loss in your taxable account and within 30 days purchase a convertible security, such as a convertible bond, option or warrant, that will draw unwanted attention from the IRS. 

Best Tax Preparation Services for Traders

Pros and Cons of Wash Sales

Pros:

• Triggering the wash-sale rule doesn’t mean you necessarily lose all the capital-gains-tax advantage of selling at a loss. It just means that your cost basis may be higher, which is a tax disadvantage. 
• You can swap out a stock with a loss for a stock in the same industry without triggering the wash-sale rule.
• You can use strategies for selling at a loss and replacing the security by waiting more than 30 days.

Cons:

• You can’t sell at a loss in one account and buy in another without triggering the wash-sale rule.
• You must check all your 1099-B forms from various brokerages to determine whether you’ve violated the rule.
• The wash-sale rule does not apply to calendar years. It’s always based on 30 days. You can’t sell at a loss on December 31 and buy again on January 2 — that would violate the rule. 

Use Caution and Strategies to Avoid a Wash Sale

Fortunately, it’s not particularly difficult to avoid a wash sale, as long as you know the rules. 

When you sell a stock with a loss, you must wait 30 days before buying it back in any of your accounts. Alternatively, you may choose a similar investment that does not fall under the “substantially identical” category. 

Planning your buys and sells will help you avoid a wash sale. 

Frequently Asked Questions