What is a Wash Sale?
The IRS created wash sale rules to prevent investors from forming artificial losses (Publication 550). For example, if you close a position at a loss today to reduce your gains, then reestablish the same position or "substantially identical" position a week later, the loss from the first closing trade will defer and become a wash sale. When considering to incur a loss for the sake of lowering your taxable gain, there are some things to keep in mind. Below we will decode some nuances of a wash sale so you can stay on top of it if or when you encounter this on your tax forms.
Wash sales rules apply to securities–stocks/ETF shares and equity options. Wash sale rules do not apply to cryptocurrencies or Section 1256 products–futures, options on futures, and broad-based index options/cash-settled index options.
What causes a wash sale?
Reestablishing a substantially identical security position 30-days before or after incurring a loss
The most classic example of a wash sale is reestablishing a position after incurring a loss. That means if you close a position at a loss today, then reestablish that position, or "substantially identical" stock or security a week later, it will create a wash sale.
The IRS wash sale rules apply when you reestablish a substantially identical security position 30 days before or 30 days after closing a security position at a loss. The IRS rule specifies that the only way to reestablish and mark a loss against your overall taxable gain is after 30 days from your last closing order.
What is a "substantially identical" position? The obvious example is trading the same stock or ETF. However, the not-so-obvious instance is selling an ITM naked put after incurring a loss on the sale of 100 shares since a naked put also accounts for 100 long shares of stock. For example, taking a loss on a stock position by selling 100 shares @ $55/share, then immediately selling a $55 put in that same underlying that you originally bought 100 shares. The loss from the stock position would not be valid since the sale of the $55 put effectively makes you synthetically long shares at $55. The same logic applies to incurring a loss on -100 short shares and immediately selling an ITM short call after incurring a loss.
Getting assigned or (auto) exercising an option
After incurring a loss on long or short shares, any option positions resulting in shares from an assignment or (auto) exercise within 30 days can incur a wash sale. Since an option assignment or exercise results in shares, it reestablishes a share position, including in-the-money spreads that offset each other.
Order Fills via Best Execution
At tastyworks, orders fill via best execution, or what we call in the industry "best ex." In short, best execution means that any order submitted will route to the best exchange to get filled. As a result, when you submit an order with a quantity greater than one, your order potentially can split up in the background to multiple venues to get the best available fill.
So, why does this matter? When submitting a closing order for a securities order for quantities greater than one, any immediate loss incurred due to best execution may generate an unexpected wash sale. In most cases, if you did not reestablish the position within 30 days after closing out your entire position, then nothing gets disallowed despite the wash sale listing.
How does Apex report wash sales?
Our clearing firm, Apex Clearing Corporation, interprets wash sale loss disallowances based on securities with the same CUSIP or identifier. A common wash sale question is with rolling options. For example, let's say it's January, and you sell a monthly January XYZ 100-strike put, and it gets tested, so you end up rolling the option month over month for six straight months. Despite the short put having the same resulting position (+100 long shares) and strike, each rolling order and option would be treated separately and not subject to a wash sale since each monthly options series has a different identifier.
Wash Sale Examples
Portfolio Realized Gain: $10,000
|Stock||Quantity||Cost Basis||Current Mark||P/L|
You've done well over the year trading stocks and options, and you want to reduce your overall gain to reduce your total tax bill. You still have faith in XYZ and want to hold it for the long run. You decide to sell your XYZ stock position that is currently marking at -$1,000 loss to reduce your P/L from $10,000 to $9,000.
A week later, you decide to repurchase XYZ at $12 to take advantage of the lower price and the conviction you have for the stock in the long run.
A week later, you decide to repurchase XYZ at $12 to take advantage of the lower price and the conviction you have for the stock in the long run. Unfortunately, the $1,000 loss you initially anticipated to deduct against your portfolio's realized gain no longer applies because you reestablished XYZ within 30 days after incurring your initial loss.
As a result of wash sales rules, the $1,000 loss gets added to your new cost basis. This means when you repurchased the stock at $12 you new cost basis becomes $22 ($12 + $10 = $22).
|New Cost Basis Under Wash Sale|
|Stock||Quantity||New Trade Price||Prior Loss||New Cost Basis|
At first glance, it looks like your loss on XYZ is forever lost, but it's not. The entire loss will incur when you decide to close the entire XYZ position and not reestablish it after 30-days.
Wash Sales from Best Execution
Wash sales from best execution are probably the biggest head-scratcher when it comes to seeing a wash sale list on your Consolidated 1099. Before we dive in, let's see best ex in action with an opening and closing order on an 8-lot of AMZN 3750 strike calls.
Below, are two orders–an opening order (green arrow) filled at $12.25 debit/leg and a closing order filled at $0.12 credit/leg (red arrow).
Example of two separate 8-lot AMZN 3750 strike call orders
Due to best execution, the opening order on the 8-lot of AMZN 3750 strike calls instantly split into six separate lots when filled with getting the best available price at multiple venues (green outline). The same applies to the closing order getting divided into two lots totaling the 8-lot (red outline). However, this is when a wash sale can occur. Since the order separated into two separate lots, the 1-lot incurred a wash sale (red arrow), despite the remainder instantly filling after it.
Example of best execution with the opening and closing 8-lot order
When referring to the Consolidated 1099, you'll see that due to best ex the loss on the first 1-lot leg created a wash sale for $1,214.29 (green arrow). Despite the wash sale listing as part of the closing transaction, the big takeaway from this example is the $9,714.22 loss already accounts for the wash sale (red arrow). Simply put, there were no disallowed losses. You can back into this by referring to the yellow box in the History tab screenshot above (-9704 - 8 - 2.22 = -$9,714.22).
Example of the 1099 listing a wash sale on the closing trades