In a nutshell, a wash sale occurs when you sell a security (stock, bond, or mutual fund, for example) at a loss, either followed by or preceded by a purchase of substantially the same security within 30 days of the sale.
The IRS disallows the recognition of the loss for tax purposes in such cases. Without the purchase portion of the set of transactions, you would be allowed to utilize the capital loss to offset other capital losses and possibly offset ordinary income, depending upon the circumstances.
The Details
When you sell, at a loss, a security of any sort that would be treated as a capital item, the loss will be disallowed for tax purposes if you purchased substantially the same security within 30 days before or after the sale:
In a taxable account or a deferred account (all accounts under your household are counted together, that is, yours, your spouse’s, and any corporation you control) or as options or futures contracts.
Of course, the initial sale of the security must be within a taxable account – that is, not within an IRA or other deferred-tax account. This is because we’re referring to capital gains treatment of gains and losses, which do not apply to IRAs and deferred-tax accounts.
Prior to Revenue Ruling 2008-5, one could effectively purchase a new, substantially same position in your IRA or Roth IRA within the 30 day period after the loss sale in your taxable account, and it would not engage the wash rule. This has been disallowed now.
So what makes up a substantially identical security?
In the IRS’ own words:
In determining whether stock or securities are substantially identical, you must consider all the facts and circumstances in your particular case. Ordinarily, stocks or securities of one corporation are not considered substantially identical to stocks or securities of another corporation.
However, they may be substantially identical in some cases. For example, in a reorganization, the stocks and securities of the predecessor and successor corporations may be substantially identical.
Similarly, bonds or preferred stock of a corporation are not ordinarily considered substantially identical to the common stock of the same corporation.
However, where the bonds or preferred stock are convertible into common stock of the same corporation, the relative values, price changes, and other circumstances may make these bonds or preferred stock and the common stock substantially identical. For example, preferred stock is substantially identical to the common stock if the preferred stock:
- Is convertible into common stock,
- Has the same voting rights as the common stock,
- Is subject to the same dividend restrictions,
- Trades at prices that do not vary significantly from the conversion ratio, and
- Is unrestricted as to convertibility.
The above is quoted directly from IRS Publication 550.
The question comes up all the time – I always say as a rule of thumb that if you have to question whether your choice of a replacement is substantially identical or not, then it’s not worth it to have to argue the point with the IRS when you’re audited. It’s only 30 days, after all.
Examples of Wash Sale Avoidance
Below are a few examples to help understand the idea of substantially identical, and how to avoid it in practice.
Example 1: You sell, at a loss, shares of a mutual fund that is invested in the S&P 500 index. On the same day you purchase a mutual fund that is invested in a total stock market index. The two investments are not substantially identical, so you avoid wash sale treatment. If you instead purchased another mutual fund (perhaps with another fund family) that invests in the S&P 500 index, you will be subject to the wash sale rules because the new fund is substantially identical to the original fund.
Example 2: You sell, at a loss, shares of a mutual fund that owns a portfolio of Treasury Inflation-Protected Securities (TIPS). Within 30 days you use the proceeds from the sale to purchase another mutual fund that invests in GNMA bonds (Government National Mortgage Association, or Ginny Mae). This set of transactions avoids the wash sale, because GNMA bonds are not identical to TIPS.
Example 3: You sell your S&P 500 index investment mentioned in example 1. You wait 30 days, and on the 31st day you purchase the exact same (or another fund family’s) S&P 500 index investment. This set of transactions avoids wash sale treatment because enough time has passed (30 days) since the sale for a loss.
Examples for Handling Wash Sale Disallowed Losses
So, instead of allowing the loss, the IRS gives you the ability to increase the basis of the security that you purchased, by the amount of loss that you were disallowed.
Example 1: You own 100 shares of stock that you purchased last year for $1,000. You sell those shares for $750, and within 30 days, you purchase another 100 shares for $800. You have a disallowed loss of $250, which will be added to the basis of your current holding, making the basis now $1,050 ($800 plus $250).
Example 2: You purchase 100 shares of stock for $1,000, and then sell them for $750 within 30 days. Your loss is disallowed. In this case, since you don’t own the stock any more, the loss is just gone, unless you repurchase the position within 30 days.
Example 3: You own 100 shares of stock that you purchased last year for $1,000. You sell all 100 of those shares for $500, and within 30 days you purchase 50 shares again for $200. These 50 shares will have a basis of $450 due to the disallowed loss of $250. You would still have an allowed loss of $250 for the activity unless you repurchased additional shares within 30 days.
It can get really complicated if you have multiple purchases and sales and overlapping 30 day periods, so if you have a particular situation that you’d like to review, please let me know. Other complicating factors include the use of short sales, options, and futures contracts.
This article has been republished with permission from Financial Ducks in a Row.