Don’t make this critical mistake that keeps you from harvesting losses on taxable investments
The silver lining to losing money in the stock market is getting a tax benefit. Recording a loss is as simple as selling the losing investment – and when your capital losses exceed your capital gains, you can take a tax deduction for the difference.
But there’s a critical misstep that can stop you from achieving the tax reward: triggering the wash sale rule. The wash sale rule impacts all stocks, bonds, mutual funds, and options – basically, any investment that can generate a taxed capital gain.
Congress enacted the wash sale rule to keep people from selling securities with the sole intention of lowering their taxable income. Previously, investors could unload a losing stock and then snap it up again a minute later, cleverly locking in a tax-reducing loss and retaining ownership at the same time.
What is a wash sale?
In the eyes of the IRS, a wash sale occurs when you sell a security at a loss and then purchase the same security or a “substantially identical” one within 61 days: 30 days before or after your sale date. The rule comes into play even if the transactions occur in different calendar years.
Buying a contract or option to buy the same or substantially identical securities won’t fool the IRS, nor will purchasing them for your individual retirement account. Selling an investment at a loss and then having your spouse or a corporation you control buy it back within the wash sale time frame will also trigger the rule.
When the wash sale rule is tipped, your loss is disallowed and added to the cost basis of the securities you rebought. Even investors who don’t mean to break this rule are often caught by it if they use an automatic investment strategy like reinvesting dividends.
Let’s be clear: it isn’t illegal to do a wash sale. But it’s illegal to claim an undeserved tax benefit.
Consider this example: You own 100 shares of XYZ stock that you purchased at $50 a share. The current market price is $25 – resulting in a $25 per share loss or $2,500. You have gains from other investments, and you know that if you book this loss in the calendar year it will offset them and reduce your tax burden.
You decide to sell the XYZ stock and record the $2,500 loss. To rightfully record this loss on your taxes, you can’t purchase XYZ stock within 30 days before or after your sale. If you do, it’s considered a “wash” and the capital loss is deferred until you sell the new, replacement shares.
If you continue to sell and replace these shares with “substantially identical” ones, the loss is carried forward with each transaction until the shares are liquidated for longer than the wash sale time period.
What does “substantially identical” mean?
There is much debate about what defines a “substantially identical” investment; the vague IRS warning to “consider all the facts and circumstances” leaves a lot of room for interpretation. Generally, stocks, preferred stocks, and options issued by one corporation aren’t considered substantially identical to those of another. That means if you sell Apple and buy Microsoft, you shouldn’t trigger the wash sale rule.
But the rules get murkier in other scenarios. Corporations can be considered substantially identical if they are a predecessor or successor corporation in a reorganization, so make sure you do your homework to ensure there is no connection. Most tax advisors would also urge you to shy away from replacing one S&P 500 index mutual fund with another. Even though they have different ticker symbols, expense ratios, and fund managers, their holdings could be similar enough to trigger the wash sale rule.
How to avoid a wash sale
The simplest way to avoid a wash sale is waiting until the 61 day wash sale period is over before repurchasing the same or a similar investment. If you really want to book the loss but remain invested in a similarly performing security, it’s critical that you use your best judgment to choose one that’s not “substantially identical” to the one you unloaded.
Are wash sales ever beneficial?
If your capital gains wind up being taxed at a 0 percent tax rate, you won’t get any tax benefits from claiming a capital loss. In that case, triggering the wash sale rule and deferring the loss to another year might help you take better advantage of potential tax savings.
Is there any upside to adding the loss to the cost basis of the replacement securities?
Like previously noted, your disallowed loss doesn’t simply disappear in a puff of smoke; it’s added to the cost basis of the new securities you purchase. When you sell those, the old loss will effectively reduce your gain or increase your loss on the transaction.
The holding period of the wash sale securities is also added to the holding period of the securities you replaced them with, increasing your odds of qualifying for the better tax rate of long-term capital gains. Tax rates are currently 0 percent, 15 percent, or 20 percent for gains on assets held for more than a year. If assets are held for less than a year, gains are taxed in the investor’s ordinary income tax bracket, where rates can reach as high as 37 percent.
Achieving a tax benefit on investment losses can alleviate some of the sting of paying taxes on gains or absorbing losses from investments that didn’t pan out. But it’s easy to make a mistake that triggers the wash sale rule when you try to reinvest the money you made on the sale of the losing securities. An experienced tax advisor can help you avoid the financial pain of unexpected wash sales by guiding you toward actions that won’t break the rule.
Provident CPA & Business Advisors serves successful professionals, entrepreneurs, and investors who want to get more out of their business and work less, so they can make a positive impact in their lives and communities. Typically, our clients reduce their taxes by 20 percent or more and create tax-free wealth for life. Contact us for expert advice on tax planning, and to find out how we can help your business exceed your expectations.