A wash sale, in a nutshell, is a rule created by the IRS (Publication 550) that prevents investors from forming artificial losses. There are some things to keep in mind when looking to use a loss to lower your overall tax bill or if you happen to see this in your tax documents. Below we will decode the nuances of a wash sale so you can stay on top of it if or when you encounter this on your tax forms.
What is a Wash Sale?
Re-establishing a substantially same security position 30-days before or after closing for a loss
A wash sale is an IRS rule that prevents investors from recognizing artificial losses. That means if you close a position at a loss today to reduce your gains then re-establish that position, or “substantially identical” stock or security, a week later it will defer the loss. An example of a “substantially identical” stock or security would be 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.
In a nutshell, the IRS wash sale rules apply when you re-establish a substantially same 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 re-establish and mark a loss against your gain is after 30 days from your last closing order.
Let’s do an example
Portfolio Realized P/L YTD: $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 realized P/L YTD to reduce your total tax bill, but 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 (7 days 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 originally anticipated to deduct against your portfolio’s realized P/L no longer applies due to the wash rule since a “substantially identical” stock or security was re-established within 30 days.
Additionally, the $1,000 loss is now 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, this might look like your loss is forever lost, but it’s not. The loss can be used if you decide to close it another time as long as the position is not reestablished in a 30-day window.
Another example of a “substantially identical” position would be taking a loss on a stock position @ $10/share then selling a $5 put. Again, the $1,000 loss is not valid since the put that was sold effectively brings you back to the same position.