Wash Sale

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A wash sale is a transaction in which you sell a security at a loss and then, within 30 days of the sale, buy a security that is virtually identical to the one you sold. Because the sale and purchase are treated as one transaction for tax purposes, the IRS does not permit you to claim the loss on your tax return. 

When you eventually sell the new security, you will have a lesser taxable gain or a bigger deductible loss because the disallowed loss is added to the cost basis of the new security.

Why would someone do a wash sale?

In order to balance off other taxable profits, one rationale could be to inflate a loss. Imagine, for instance, that you have a stock that has increased in value and wish to sell it to lock in your profit. In contrast, you also own a stock whose value has decreased and which you believe will shortly increase again. You could try to deduct the loss from your taxes and lower the tax on the winning stock by selling the lost stock and buying it again within 30 days. But because of the wash sale rule, this tactic would be ineffective.

Maintaining your position in security while benefiting from a brief drop in its price is another potential explanation. For instance, imagine that you own a stock with what you perceive to be long-term growth potential, but that value has lately decreased as a result of negative news or market volatility. You could try to minimize your cost basis and boost your future return by selling the stock and buying it again within 30 days. The wash sale rule would apply to this tactic as well, and you would not be allowed to deduct the loss from your taxes.

How can you avoid a wash sale?

A wash sale rule can be avoided in a few different ways. One strategy is to hold off on repurchasing security for more than 30 days after selling it at a loss. This will allow you to deduct the loss from your taxes and keep any price recovery proceeds.

A different option is to purchase a security that is not nearly comparable to the one you sold. If you sold a business's shares, for instance, you could purchase the stock of a different company operating in the same industry or sector or an exchange-traded fund (ETF) that monitors the performance of that sector. You can continue to expose yourself to the same market niche in this way without breaking the wash sale rule.

A third option is to sell all of your shares of a security at a loss and refrain from purchasing any additional shares of that same investment within 30 days after the transaction. In this manner, you can deduct the loss from your taxes and steer clear of any potential wash sale issues.

What are some examples of wash sales?

Here are some hypothetical scenarios that illustrate how wash sales work:

• Example 1: You spend $10,000 on 100 shares of XYZ stock on January 1. You sell all of your shares at $8,000 on January 15th, suffering a $2,000 loss. XYZ lowers to $8,000 on that day. If XYZ increases to $9,000 on January 20th, you would then purchase 100 shares for $9,000 again. This transaction is a wash sale as you purchased shares that are nearly identical to the ones you sold for a loss within 30 days of the sale. The $2,000 loss is ineligible for a tax deduction. As a substitute, you add it to the cost base of the new shares, which rises to $11,000 ($9,000 + $2,000). If you later sell the fresh shares for $12,000, instead of $3,000 ($12,000 - $9,000) as would be the case if there was no wash sale, you will instead have a taxable gain of $1,000 ($12,000 - $11,000).
• Example 2: On January 1st, you invest $10,000 in 100 shares of the ABC stock. You sell all of your shares for $8,000 on January 15th, suffering a $2,000 loss. ABC lowers to $8,000 on that day. You purchase an option contract on January 20th, at which point ABC rises to $9,000, entitling you to purchase 100 shares of ABC at that price at any time before March 31st. Additionally, this is a wash sale since, for taxation purposes, an option contract and its underlying stock are deemed to be substantially identical.