Know the Tricks and Traps of the ‘Wash Sale’ Rules

Few taxpayers were interested in or needed to know the “wash sale” rules, until recently.

When stock prices rose steadily, the wash sale rules didn’t come into play. The rules matter only when investors sell stocks at losses. That’s why the wash sale rules have been more important since 2021.

The wash sale rules were created to prevent taxpayers from figuratively having their cake and eating it too.

When the price of a stock or other investment declines, investors are advised to engage in tax loss harvesting. Sell the losing investment so the loss can be deducted against capital gains and other income. (See our October 2022 issue for details about this strategy.)

But the investor might like the investment’s long-term prospects and not want it to be out of the portfolio for long. The investor wants to re-purchase the investment after selling it.

Congress decided investors should be able to deduct an investment loss only when the investor really was out of the market and takes the risk of missing a rebound rally.

The wash sale rules say you can’t deduct an investment loss when, within 30 days of the sale, you replace the investment with one that is the same or “substantially identical.”

The loss deduction isn’t disallowed forever. It is only deferred. The loss incurred on the sale is added to the tax basis of the investment purchase that violated the rules. The higher basis increases the loss or decreases the gain when that second holding is sold.

The wash sale rules typically are triggered when an investor sells a stock and buys the same stock within 30 days.

But the wash sale rules also are triggered when the investor buys more of the investment first and then sells the shares he or she already owned at a loss. It doesn’t matter in which order the transactions are made. A combination of purchases and sales within 30 days of each other trigger the loss disallowance.

The 30-day rule also trips up some people. The loss is disallowed when the transactions occur within 30 days of each other. You must wait more than 30 days before making the second transaction. Make the second transaction on the 30th day, and you can’t take the loss deduction.

It’s best to look at the waiting period as 61 days, more than 30 days both before and after the sale of the investment with the loss.

The wash sale rules apply only to transactions involving “securities,” which generally are stocks, bonds, mutual funds and ETFs. Options and futures also are securities. For example, if you sell a stock and buy an option contract on that stock within 30 days, the rules are triggered.

The securities don’t have to be publicly traded for the wash sale rules to apply, so they can be violated in transactions involving privately held businesses or other securities.

The tax code and regulations are vague about when two securities are substantially identical. Of course, you fall into the wash sale rules if you buy and sell the common stock of the same company. Bonds or preferred stock generally are not substantially identical to common stock of the same company, but they might be if the bond or preferred stock is fully convertible into common stock.

Tax advisors generally agree that you can sell the stock of one company and buy the stock of another company in the same industry without having a wash sale. Similarly, you should be able to sell a stock and buy an ETF that focuses on that company’s sector or industry. But that might not be the case when a single-stock ETF is involved.

You also should be able to sell a mutual fund or ETF and buy another fund or ETF that has the same strategy or goal, especially when the two funds have different parent companies, investment managers and expenses.

After the 61-day period has passed, you can sell the replacement security and replace it with the original security you sold.

The wash sale rules don’t apply to sales of real estate and physical commodities. But they do apply to transactions involving securities of mutual funds, ETFs or other entities that are backed or invested in some way in real estate or physical commodities. As mentioned above, futures and options contracts are securities under the wash sale rules, even when the futures and options relate to commodities.

The IRS indicated that digital currencies or cryptocurrencies, such as Bitcoin, are not securities. They are investment properties, more similar to real estate than stocks. So, the wash sale rules don’t apply to the digital currencies. That might change, because Congress is considering regulating the digital currencies as securities.

You have to be aware of transactions by some other taxpayers, because transactions by parties related to you can trigger the wash sale rules on your transactions.

For example, if your spouse or a corporation you control buys a security within 30 days of when you sold the identical security at a loss, a wash sale has occurred. The purchase by the related party is treated as a purchase by you.

The IRS also has ruled that an IRA or other retirement account is a related party to its owner. If you sell a security at a loss in a taxable account and buy the identical security in an IRA within the 60-day period, there has been a wash sale.

In this case, you really are deprived of the loss deduction. The IRS ruled the disallowed loss in your taxable account doesn’t increase your tax basis in the IRA. So, you won’t ever receive a tax benefit from the loss.

The ruling applies to both Roth and traditional IRAs, when the taxable account and the IRA are at different financial institutions.

When a wash sale occurs, it is reported on Form 8949, which must be filed with your income tax return for the year.