As defined in Investopedia.com, the wash sale rule is an Internal Revenue Service (IRS) rule that prohibits a taxpayer from claiming a loss on the sale or trade of a security in a wash sale. The rule defines a wash sale as one that occurs when an individual sells or trades a security at a loss, and within 30-days before or after this sale, buys a “substantially identical” stock or security, or acquires a contract or option to do so. A wash sale also results if an individual sells a security, and the spouse or a company controlled by the individual buys a substantially equivalent security.
What happens to your loss once it is disallowed?
The only good news about wash sales is that your disallowed loss doesn't just disappear. Instead, the loss gets added to the basis of the replacement securities. When you sell the option or stock, your disallowed loss effectively reduces your gain or increases your loss on that transaction.
Below is an example that may help clarify the mystery of the wash sale rule.
Say you purchased 50 shares of ABC Co. on April 1, 2016, for $2,000. On April 5, 2016, you sell the shares for $1,200, thus incurring an $800 short-term loss. But on April 10, 2016, you have a change of heart thinking the stock price may be going up, and decide to repurchase 50 shares of ABC Co. for $1,300. Your $800 loss is disallowed by the IRS because you bought the same stock within 30-days of the previous sale. The loss gets added to the basis of the replacement shares. So your basis becomes $2,100 (new cost of $1,300 plus the short-term loss of $800).
As you can see from this example, a wash sale usually isn't a total financial disaster. In most cases, it just means that you will get the same tax benefit at a later time according to the definition as stated above. Be sure to consult with your tax advisor to get a thorough understanding of your own tax consequences when purchasing and selling stocks and/or options.
How can you as a trader plan for wash sales?
Here are some ideas for you to consider when trading to work within the wash sale rule:
- You can sell the stock you own, and wait 31-days before buying it again. The risk in this instance is that the stock price could increase before you can repurchase it, and therefore, not realize the potential profit from the stock's rise in price.
- If the stock has a strong tendency to move in tandem with another stock, you may be able to reduce your risk of missing a gain by purchasing stock in a different company as the "replacement" stock. This is not considered a wash sale because the stocks are not identical. Thirty-one days later you can switch back to your original stock, if that is your desire. However, there is always the risk that the two stocks will not move in the same direction as you believe they will.
There is no risk-free way to guarantee a wash sale rule will not occur. It's important for a trader to evaluate all the risks, and balance them against any potential benefit you receive if you can claim the deduction for any loss.
This video produced by T.D. Ameritrade has some additional information on the wash sale rule you may find helpful: https://youtu.be/R7OmiwjGsZE
As I mentioned earlier, please consult with your financial/tax advisor on how the wash sale rule may affect your own trading plan.
If you are looking for a resource to share trade ideas, and learn from veteran traders, consider joining https://capitaldiscussions.com/join. It is an excellent community of traders of all experience levels willing to share their knowledge with other traders.
Feel free to comment/share your experience with wash sales that others may benefit from.