Throughout the year, and particularly as the end of the year approaches, many investors and traders are looking at their investment portfolios and trying to find ways to minimize their tax burdens, this is especially true of active traders. Some of those who are new to investing may think that they can simply sell a stock for a loss, buy it back later, and write the loss off on their tax return. While in principle this is true, it is more complicated, as is any tax rule. Be careful to avoid a wash sale or at least know how to deal with one. The last paragraph summarizes this article, but it is highly recommended that the details are understood. Specifically, read and understand IRS Publication 550 and IRS Publication 17.
As in any government regulation, the simplest thought is not always the correct one. If stock is sold for a profit, taxes are required to be paid on the profits. While this sounds simple, it also is not. If stock has been held for one year or less, it’s subject to “short-term” capital gains taxes; more than one year, “long-term” capital gains. This is not the subject of this article, but it’s still relevant. If a stock is sold for a loss, that loss can be written off as a capital loss unless there is the repurchase of the same stock or a complexly defined, “substantially identical” stock, within thirty days of the sale. If the same stock or a “substantially identical” stock is repurchased within thirty days, before or after the sale, the sale is considered a “Wash” and can not be claimed as a loss. If an investor sells a stock for a loss and repurchases the same stock too soon and then the stock increases in value, that investor will then, essentially, be paying capital gains taxes on money that they lost; but this is also not that simple.
This excerpt comes from IRS Publication 17 chapter 14 and IRS Publication 550 chapter 4…
“If your loss was disallowed because of the wash sale rules, add the disallowed loss to the cost of the new stock or securities (except in (4) above). The result is your cost basis in the new stock or securities. This adjustment postpones the loss deduction until the disposition of the new stock or securities. Your holding period for the new stock or securities includes the holding period of the stock or securities sold.”
You don’t actually lose the ability to deduct the loss, but you must recalculate the new cost basis. Do this very carefully, you don’t want any complications in your tax filing. If a mistake is made and all transactions take place within the same tax year, you will have to correct and re-file that year’s taxes; however, if the wash sale and repurchase happens in one year and the subsequent sale happens in the next year, the necessary corrections will be much more of a headache.
Whether you prepare your own taxes or have them prepared by an accountant, it’s good to understand as much of the relevant tax code as possible. Yes, this is a lot to ask, especially since those who write and implement the tax code don’t understand all (or seemingly much) of it, since we’re expected to pass legislation in order to find out what’s in the bill. The consequences of doing this wrong will most likely not land somebody in prison, but it will at least complicate the tax filing and cause delays and other problems and may result in penalties.
In summary: if you sell a stock at a loss and repurchase the same stock within thirty days, you can not claim the loss on that sale, because it is considered a “wash” sale. You can add the loss, from the sale, to the new repurchase price, in order to establish a higher basis price; this essentially gives the same result in a delayed sense, but it just makes it more convoluted. Also, as if investing isn’t risky enough on it’s own, investors are required to pay taxes on an unlimited amount of gains, but are permitted to claim no more than $3,000 in losses in a given year, so keep that in mind, too. This article is not tax advice and should not be relied on for instructions on fulfilling a tax filing; it is for informational purposes only. Always verify the current year’s tax code and instructions and/or get help from a qualified professional accountant or tax preparer.
United States Treasury Internal Revenue Service, “IRS Publication 550 Investment Income and Expenses, www.irs.gov
United States Treasury Internal Revenue Service, “IRS Publication 17 Your Federal Income Tax For Individuals, www.irs.gov