A wash sale occurs when the taxpayer sells securities to claim a loss, but then the taxpayer or a closely related party buys substantially identical securities, which are securities that are the same or that can be converted into the sold securities, within the wash sale period. The wash sale rule disallows the claiming of losses for securities in a wash sale. Securities that are sold at a gain are not subject to the wash sale rule. Traders with professional trader status are not subject to the wash sale rules. The wash sale period is 61 days long, from 30 days before the date of the sale to 30 days afterward.
Example: On January 5, you buy 100 shares of stock for $900. On July 1, you sell the shares for $500, but then, on July 15, you repurchase the shares for $600. Therefore, you cannot deduct a loss of $400. Instead, you must add the $400 to the basis of the repurchased stock, so the tax basis for the stock will be $1,000. Your holding period for the new stock begins on January 5, when you bought the original 100 shares. On March 9 of the following year, you sell your 100 shares for $1,700. Therefore, you have a long-term gain of $700.
Tax Tip: Because the wash sale rule only applies to losses, securities sold at a gain can be repurchased quickly, which may be advantageous in some cases. If you expect to be in a higher tax bracket in the next tax year, then it may be beneficial to sell securities to be able to claim the gains while in the lower bracket, then rebuy the securities in the following tax year. The basis in the new securities will be equal to the purchase price plus the buying commission, which will usually result in lower gains in the new or later tax years, yielding a lower profit subject to the higher tax rate. The risk in this, of course, is that the securities may increase in price between the time they are sold and the time they are rebought, but if it is done at the end of the tax year, then they can be rebought on the 1st trading day of the new tax year.
Losses on short sales are also subject to the wash-sale rules. However, the wash sale rules do not apply to acquisitions by gift, inheritance, or tax-free exchanges (IRC §1091).
Substantially identical securities includes securities or contracts that can be converted into the sold securities, including put or call options, and warrants that can be converted to the securities. However, the wash sale rules do not apply to commodity futures contracts and foreign currency contracts. Preferred stock, bonds, and the common stock of a corporation are considered separate securities, unless the preferred stock or bonds can be converted into the common stock, in which case, they are considered substantially identical securities. The wash sale rules do not apply to dealers who are in the business of buying and selling securities, if the trades are made during the course of business.
Bonds are considered substantially identical securities if they pay the same rate of interest and are issued by the same company. Different payment dates do not differentiate the security sufficiently for the wash sale rule not to apply; even different maturity dates will not be significant unless the difference in the terms of the bonds are significant. To be considered different securities, the 2 bonds must differ by at least 2 of the following: maturity date, interest rate, credit rating, or issuer.
The wash sale rules also apply if anyone closely related to the taxpayer buys substantially identical property within the wash sale period. Closely related parties include the spouse, siblings, parents, grandparents, and descendants, and closely held corporations where the taxpayer is a major owner.
The wash sale rules apply even if the security is repurchased through a traditional or Roth IRA. Although IRAs are considered independent entities for tax purposes, the wash sale rules cannot be avoided because the taxpayer sold the shares but the IRA repurchased them, and, indeed, an additional penalty is incurred by buying the replacement shares through an IRA because the disallowed losses are not added to the tax basis of the shares in the IRA.
Example: You buy XYZ stock for $10,000 in January. On December 30, you sell the stock for $8,000, incurring a $2,000 loss. On January 21 of the following year, you buy the same stock back for $9,000. Your $2,000 loss will be disallowed for the previous year. Instead the $2,000 disallowed loss will be added to your stock basis so the basis of the newly purchased stock will be $11,000. However, if your IRA had purchased the stock, then your basis would remain $9,000.
If substantially identical property is bought during the wash sale period, then only the amount of loss realized on the same number of repurchased shares is disallowed. The remaining loss is deductible.
Example: You buy 100 shares of XYZ stock for $10,000. At the end of the tax year you sell the stock for $8,000, incurring a $2,000 loss. However, you repurchase 50 shares for $3,000 on January 23. Therefore, $1,000 of your initial loss is deductible and the remaining $1,000 of disallowed loss is added to the basis of your repurchased stock, so your 50 shares of stock will have a tax basis of $4,000.
If the taxpayer has several blocks of securities bought at different times and at different prices, and sells them on the same day and in which the wash sale rules apply to at least to some of the securities, then any losses on the sale day cannot be used offset the gains on that same day.
Example: You buy 100 shares of XYZ stock for $50 per share, then, at a later date, you buy another 100 shares for $60 per share. On August 1, you sell your 200 shares for $55 per share. On August 15, you buy 50 shares of XYZ stock for $35 per share. Therefore, you cannot offset your gain of $500 on August 1 with your loss of $500 on that same day. Instead, you have to report a net gain of $500 for your August 1 sale, and the $500 of disallowed losses is added to the tax basis of the stock purchased on August 15. Therefore, your basis for the stock is equal to the $35 purchase price plus the apportioned share of your disallowed losses, equal to $10 per share, for a total basis of $45 per share.
If a wash sale was conducted from the same brokerage account, then the broker should send the taxpayer a Form 1099-B, Proceeds from Broker and Barter Exchange Transactions reporting the wash sale. The transaction is reported on Form 8949, Sales and Other Dispositions of Capital Assets in the tax return.
Note that special rules apply to straddles and real estate mortgage investment conduits (REMICs).