Be mindful of how – and when – losses are used to offset gains.
Ever since the federal tax code was created, losses have been used to offset gains – just like teeter offsets totter and yin balances yang. But it’s how you arrive at a loss that may draw the ire of the IRS.
The Internal Revenue Service created the wash sale rule as a way to stop taxpayers from creating losses on paper by selling securities at a loss only to buy them back soon after, thus creating what the IRS deems a “wash.” For federal income tax purposes, the loss on a sale is disallowed if you add substantially identical investment securities, including both stocks and bonds, and also substantially identical mutual funds and ETFs in any of your accounts – or acquire a contract or option to do so – to the ones sold within a 61-day period that begins 30 days before the date of the loss sale and ends 30 days after the date. If this happens, you cannot take the anticipated federal tax deduction. The rule only applies to losses, by the way. Sell for a gain, and Uncle Sam collects his share in the form of capital gains taxes.
A different but similar rule applies if a person or entity (such as your IRA) related to you buys the replacement investment. Your loss may be treated as if you made an indirect sale to a related person and could be disallowed.
Just because the wash sale was disallowed doesn’t mean the deduction disappears. The disallowed loss becomes a deferred loss when added to the cost basis of the replacement investment. When you sell the replacement shares, you can recognize the previously disallowed loss. Just remember, the holding period for the replacement stock includes the holding period of the original stock you sold, often effectively making it a long-term position. Let’s look at a purchase, sale and repurchase of ABC stock, which results in a wash sale rule violation:
However, if the investor in the above scenario then sells the 100 shares purchased on June 2, it’s no longer a wash sale, as long as those shares are sold before the end of the year. Why? Wash sale rules only apply to an odd number of buy and sell transactions or transactions that result in shares leftover. This investor is not subject to wash sale rules because the different transactions meet two important criteria: There is now an even number of transactions, and there are no shares leftover on which to assess gains or losses.
Even though managing gains and losses is an integral part of any investment tax plan, there are pitfalls to be avoided – one of which is the wash sale. And you can see the wash sale rule becomes an issue when you want to sell a stock or security to harvest a tax-saving capital loss yet still want to own the investment or another that is substantially similar to the one being sold. Work with your advisor to avoid any hiccups when adding to or pruning your portfolio – especially relevant as year-end reviews and rebalancing take place.
Raymond James financial advisors do not render advice on tax or legal matters. You should discuss any tax or legal matters with the appropriate professional.