Understanding Tax Terms
If selling a stock or mutual fund to book a loss for your tax return, the Wash Sale rules are worth knowing. For the unaware, this rule could cost you your loss deduction.
As you look for year-end tax moves to save on your bill from Uncle Sam, you may consider selling stocks that have lost value. This can be a great strategy when up to $3,000 in stock losses can offset your ordinary income. However, there is a little known rule called the Wash Sale rule that could surprise the unwary taxpayer.
If the Wash Sale rule applies, you cannot report a loss you take when you sell a security. Per the IRS,
A wash sale occurs when you sell or trade stock or securities at a loss and within 30 days before or after the sale you:
- Buy substantially identical stock or securities,
- Acquire substantially identical stock or securities in a fully taxable trade,
- Acquire a contract or option to buy substantially identical stock or securities, or
- Acquire substantially identical stock for your individual retirement account (IRA) or Roth IRA.
Why the rule?
Many investors were selling stock they liked simply to book the loss for tax reasons. They then turned around and immediately re-purchased shares of the same company or mutual fund. If done repeatedly, shareholders could constantly be booking short-term losses on a desired company while still owning the shares in a chosen company’s stock indefinitely. Clever shareholders would even purchase the replacement shares prior to selling other shares in the same company to book the loss.
How does one take action to ensure the Wash Sales rule works to your advantage?
- Check the dates. If you decide to sell a stock to book a loss this year, make sure you haven’t inadvertently acquired the same company’s shares 30 days prior to or after the sale date.
- Dividend reinvestment. If you automatically re-invest dividends you will want to make sure this doesn’t inadvertently trigger the Wash Sale rule.
- It is only losses. Remember the Wash Sale only applies to investments sold at a loss. If you are selling stock to capture gains, the rule does not apply.
- Consider similar transactions. The Wash Sale rule applies to buying and selling ownership in the same company or mutual fund. With the exception of some common versus preferred stocks in the same company, buying and selling similar (but not identical) shares does not apply to the Wash Sale rule.
If your loss is ever disallowed because of the Wash Sale rule you can add the disallowed loss on to the cost of the new security. When the security is eventually sold in the future, the forfeited loss will be part of the calculation of future gain or loss. This also includes the original stock’s holding period to help define the transaction as a short-term or long-term sale.