Tax Loss Harvesting and Wash Sale Rules
If an investment is not expected to perform well or to decline in the future, then that investment is usually sold to prevent or mitigate losses or to invest in better opportunities. However, some investments are sold as part of a tax strategy to lower taxes, especially at the end of the tax year. Tax loss harvesting in taxable accounts is used to reduce taxes. For securities deemed unlikely to yield a profit or to yield less of a profit than other potential investments, or if the taxpayer simply wants to reallocate assets, many taxpayers sell unprofitable securities, especially at the end of the year, to realize a capital loss, which can be used to offset taxable capital gains and, if there are no remaining capital gains to be offset, then the loss may also be used to offset up to $3000 of ordinary income, including income earned from work ($1500 if married filing separately). Any losses not used to offset capital gains or up to $3000 ordinary income can be carried forward indefinitely to offset income in future tax years. (Offsetting ordinary income is more valuable than offsetting long-term capital gains, since marginal tax rates on ordinary income tops out at 37%, while the top long-term capital gains tax rate is 20% plus a 3.8% Medicare surtax that may apply to investment income earned by taxpayers with incomes exceeding $200,000, or $250,000 if married filing jointly. However, there is a specific procedure for netting gains with losses. All capital losses must be used to reduce capital gains before they can be used to reduce ordinary income.)
Tax loss harvesting depends on negative price returns, not investment returns. A positive investment return can be received from securities that pay interest or dividends, even if the securities have a negative price return. Therefore, the securities, especially bonds, may be an excellent choice for harvesting tax losses.
Tax loss harvesting has no value in retirement accounts since any gains are not taxed until they are withdrawn, and any realized losses in these accounts cannot be used to offset income in taxable accounts or from ordinary income.
Tax loss harvesting may also have little or no value for taxpayers with only long-term capital gains to offset if they are in the 0% capital gains tax bracket for long-term capital gains. The 0% tax bracket may apply to income higher than what is shown in the table below, because these long-term capital gains tax brackets apply after deducting either the standard deduction or itemized deductions plus any 20% Qualified Business Income Deduction. For instance, a married couple filing jointly and claiming the standard deduction can earn more than $100,000 and still be in the 0% capital gains bracket.
Capital Gains Rate
|Single ||Head |
Tax Loss Harvesting May Increase Tax Credits
Because investment losses lower adjusted gross income, these losses may also increase certain tax credits based on AGI, such as the premium tax credit and the saver's credit, which would yield larger tax savings than the tax savings that would otherwise result simply from the reduction in taxable income. Some taxpayers who would not otherwise benefit from tax loss harvesting because they are in the 0% capital gains tax bracket may benefit from an increase in some tax credits, depending on their specific situation.
Another major credit that could be worth thousands of dollars for those who have children is the earned income tax credit. The relationship between this tax credit and income is more complex. The taxpayer must have earned income, the income earned from work, to qualify for this credit, but investment income may reduce the credit. If investment income exceeds $10,000 (adjusted for inflation) in 2021, then the taxpayer becomes ineligible for the credit, so harvesting tax losses can yield a significant earned income credit if the taxpayer would otherwise be ineligible because of excessive investment income. The credit for child or dependent care expenses also depends on AGI.
Some tax credits do not directly depend on AGI, but eligibility does. Furthermore, these credits have a phaseout zone where the credit diminishes as AGI approaches the phaseout maximum. For instance, the Lifetime Learning Credit and the American Opportunity Credit directly depend on educational expenses, but they do have AGI limits, making many people ineligible for these credits. So a lower AGI may make some people eligible. If AGI is within the income phaseout zone for the credit, then a lower AGI will increase the amount of the credit within the phaseout zone, up to the maximum credit for those who fully qualify. The child tax credit and adoption credit is similar to the educational tax credits, where the credit amount does not depend directly on AGI, but eligibility does. (Technically, most of these credits depend on what is called modified adjusted gross income, or MAGI, where certain deductions or excluded income must be added back to AGI before determining the amount of credit or the eligibility for the credit. However, none of these credits require adding back capital losses, so capital losses will not affect MAGI.)
However, some taxpayers try to use tax loss harvesting for investments that happen to be down at the moment but are expected to do better later, so they sell the security to claim a loss for the current tax year, then repurchase it. This strategy has reinvestment risk since the price of the security may rise before the repurchase, so, before the wash sale rules, taxpayers would repurchase the securities as soon as possible to reduce this risk. This would defer the tax to a later year, but with a basis lower than the original basis, which may yield more taxable income later. The federal government has lowered this loss of tax revenue through the enactment of wash sale rules.
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 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.
Wash sale rules also do not apply to retirement accounts. Since losses in retirement accounts are not deductible, the wash sale rules are not applicable.
Cryptocurrencies, such as Bitcoin, are not covered by the wash sale rule. The wash sale rules also do not apply to acquisitions by gift, inheritance, or tax-free exchanges (IRC §1091).
Example of a Simple Wash Sale
- On January 5, you buy 100 shares of stock for $900.
- On July 1, you sell the shares for $500.
- On July 15, you repurchase the shares for $600.
- Therefore, you cannot deduct a loss of $400. Instead, the $400 must be added to the basis of the repurchased stock, increasing the tax basis for the stock to $1,000.
- Your holding period for the new stock began 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, your long-term gain = $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 sometimes. If you expect to be in a higher tax bracket in later tax years, then it may be beneficial to sell securities to be able to claim the gains while in the lower bracket. The security can be sold to realize an immediate gain, then immediately repurchased to reduce reinvestment risk, to hold for future gains in later tax years, but with a higher basis, which will reduce any potential taxable gain.
The wash sale rules also apply to losses realized on short sales if the taxpayer already owned the securities sold short, then repurchased the same or substantially identical securities within the wash sale period of the short sale. Delivering the securities purchased before the short sale to close the short sale later violates the wash sale rules because the short sale was considered completed on the date of the short sale because the shorted security was already owned. This also applies to losses from sales, exchanges, or terminations of security futures contracts to sell. In this respect, selling short has the same tax consequences and is subject to the same wash sale rules as simply selling.
Example: How Wash Sale Rules Apply to Short Sales
- On May 5, you buy 100 shares of stock for $1,000.
- You sell short 100 shares of the stock for $800 on September 12.
- On October 1, you repurchase 100 shares of the same stock for $800.
- You close the short sale on December 17 by delivering the shares bought on May 5.
- The $200 loss (= $1,000 − $800) is nondeductible because the short sale is considered completed on the short sale date (September 12), since the security was already owned when the stock was sold short, and you repurchased the stock within 30 days from that date.
With respect to the wash sale rules, selling short a security already owned is no different than simply selling the security.
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 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.
Investors sometimes use so-called tax swaps, taking the proceeds of their realized losses to buy other securities in the same asset class, which mirror the investments they sold. Some investors will even switch back to the original securities after 30 days, but this entails reinvestment risk and potential short-term capital gains.
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. (As a practical matter, the loss of basis in a Roth IRA has no consequence, since both contributions and earnings, whatever they may be, are not taxable when withdrawn.)
Example: How Nondeductible Losses Are Added to Basis Except When Repurchased in IRA Accounts
- 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: Repurchasing Fewer Shares Than Sold
- 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: How Wash Sale Rules Apply to Same-Day Sales
- 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 must 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 = the $35 purchase price + the apportioned share of your disallowed losses = $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.
Residual Interests in a Real Estate Mortgage Investment Conduit (REMIC)
Note that special rules apply to straddles and real estate mortgage investment conduits (REMICs). The wash sale rules apply to the sale of residual interests in a REMIC, but the wash sale period is extended to 12 months: from 6 months before the sale to 6 months after. If a residual interest in any REMIC or any interest in a taxable mortgage pool comparable to a residual interest is purchased within the wash sale period, then the loss is not deductible.