Have you had a bad year in the stock market? Are you still holding on to losing investments in the hope that they will rebound and make you rich? Or maybe you just can’t bear to “take the loss” by selling them. I could make a case to hold, sell, or buy more, but I’m not writing about that this week. Instead, I’m writing to warn you about something called wash sales.
A wash sale occurs when you sell an investment at a loss, and then buy a substantially similar investment within 30 days after the sale. Notice the word substantially, a term not clearly defined by our friends over at the IRS, so I’ll do my best to explain. Wash sales can occur for investments other than stock, but for the purpose of this article, I will focus specifically on stock related wash sales.
Let me explain
Imagine it’s December 30, 2016 (the last trading day of 2016), you have some poorly performing investments, and you decide that “2017 will be a better year”, so you bite the bullet and dump your shares of fictitious entity, XYZ Corp. You know you’ll get a tax deduction for your losses (up to $3k) so you’re not 100% down and out. Until January 3, 2017 (the first trading day of 2017), when XYZ Corp announces a revolutionary breakthrough and suddenly their stock price surges. You could have been in good fortune if you had only held on to your shares, but because you sold, you’re stuck with that 2016 stock loss. You decide to buy back your shares and ride the upward trend.
Not so fast…
If you choose to buy back your shares, the tax loss you thought you would receive in 2016 will vanish. The IRS would prefer that taxpayers don’t game the system year-after-year by recognizing stock losses for tax benefits just to buy the shares back right after the New Year. This rule applies all year, not just at year-end (when this buy/sell strategy is more commonly found).
Substantially similar
In our example we used the same investment, which is blatantly a similar investment. But what if XYZ Corp is in the medical devices sector and competes directly with ABC Corp? You think the sector has potential, but maybe XYZ Corp has had some bad news in the press and is specifically not doing as well as its peers. You could stay invested in the sector by swapping your investment in companies and probably survive an IRS auditor. You couldn’t sell your XYZ Corp shares and pick up call options on XYZ Corp without risking a wash sale though. No one will stop you from actually placing the trades, and your broker may not catch the wash sale, but doing something like this is probably not going to pass under an audit or review. They are substantially the same.
They’re watching
The wash sale rule can dramatically reduce your allowable tax loss from stock sales. Your broker is required to designate wash sales on broker statements issued each year, so yes, the IRS knows about each wash sale that occurs in your account. Even if you open two separate brokerage accounts and buy & sell the same securities in each, the wash sale rule still applies. The two brokers would not know you are doing this and thus not report it, but that doesn’t make it any less of a violation of the rule.
Although the wash sale rule is in place, losses that are disallowed are rolled into the basis of the re-purchased investment until that investment remains sold for longer than 30 days. This means you don’t outright lose the tax benefit of stock losses, but you do not get to recognize the benefit until the appropriate amount of time has passed.
Conclusion
This is a sticky area of the tax code, especially when you get outside of stock related wash sales. There is no definitive ruling in place about what constitutes a substantially similar investment; so much is left to judgment. Obvious violations of the rule will be caught and enforced. Work with your broker to understand what will be flagged as a stock wash sale so you don’t lose expected tax losses at year-end.
Do you have a strategy for the end of the year to avoid wash sales? Feel free to share or comment below.