Capital loss on an investment transaction may be deferred

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A capital loss on an investment can end up being deferred to a later date if an investor repurchases the same, or substantially identical, security within 30 days before or after selling at a loss. This is known as the wash sale rule (Internal Revenue Code section 1091 ).

Example of How the Wash Sale Works

Suppose Joe has a taxable brokerage account that holds 50 shares of XYZ stock with a cost basis of $500 (that is, he bought the stock when it cost $10 per share). On July 31 the stock is worth only $5 per share, and he sells all 50 shares, producing a capital loss of $250. If Joe purchases new shares in XYZ in the period 30 calendar days before to 30 calendar days after the sell (that is, from July 1 to August 30), then Joe’s capital loss is deferred until the new, replacement shares are sold.

Wash Sale Rule Defined

A wash sale consists of two transactions: An investment sold at a loss and one of three purchase transactions occurring within 30 days before or after the date of sale:

• Buying or otherwise acquiring substantially identical stock or securities,
• Buying a contract or option to buy substantially identical stock or securities, or
• Buying substantially identical stock for your individual retirement account.

The IRS also advises that the wash sale rule is triggered if one person sells an investment at a loss and the person’s spouse or a corporation that the person controls buys the same investment within the wash sale time frame.

Wash Sales Defer Losses until the Replacement Investment is Sold

If an investor purchases the same or a substantially identical investment within the 61-day wash sale period, the loss from the sale transaction is disallowed, and the amount of the loss is added to the cost basis of the replacement investment. This functions to defer the loss until a later date when the replacement investment is sold off. The replacement investment also keeps the same holding period as the disallowed loss.

This is easy to see in the example of Joe, above, if we add some details. Joe sold 50 shares of XYZ stock for $5 per share on July 31, which he originally bought for $10 a share, incurring a loss of $250. Let’s say that Joe then also purchased 50 shares of XYZ stock on August 15, when the stock was trading at $6 per share. August 15 is within the 61-day wash sale period, so Joe’s loss of $250 is a wash sale. The $250 loss is disallowed, and Joe’s basis in the replacement shares is increased by $250. Joe’s adjusted basis in the replacement shares is (50 x 6) + 250, or $550. In other words, Joe’s actual basis in the shares (50 x 6, or $300) is adjusted by the $250 loss that was not allowed under the wash sale rule. In this example, Joe’s loss is a wash, it is just as if he held his original shares without selling.

Reporting Wash Sales on the Form 8949

All investment sales are reported on Form 8949 and then summarized on Schedule D. If a particular sales transaction is a wash sale, the IRS requires the transaction to be identified with code W in column (b) and the loss adjustment reported on column (g). See the instructions for Schedule D and Form 8949. especially the section on wash sales. for additional details.

In years prior to 2011, wash sale adjustments were reported on a second line immediately underneath the sale to show the adjustment.

Adjusting the Cost Basis for your Wash Sale Replacement Shares

Any wash sale losses are added to the cost basis of the replacement shares. In this way, the loss is deferred and recouped when the replacement shares are sold. The IRS advises, If your loss was disallowed because of the wash sale rules, add the disallowed loss to the cost of the new stock or securities. The result is your basis in the new stock or securities. This adjustment postpones the loss deduction until the disposition of the new stock or securities. Your holding period for the new stock or securities includes the holding period of the stock or securities sold (Publication 550. section on wash sales ) .

The Same or Substantially Identical Securities

Two investments are the same if they are exactly identical or if they are substantially identical. This is easiest to see in the case of the same stock, mutual fund or bond. It’s a bit harder to see where two investment securities are very similar. Passively-managed index mutual funds based on the same underlying market index may be substantially identical to each other, warns Kaye Thomas (Fairmark.com, Substantially Identical Securities ). On the other hand two bonds issued by the same issuer might not be substantially identical; bonds having different maturity dates, interest rates or other features are generally not substantially identical to each other.

Wash Sale Triggered by Repurchasing an Investment through an IRA

Selling an investment at a loss in a taxable account and purchasing the same or substantially identical investment in an IRA-based account is a wash sale (Revenue Ruling 2008-5 ). Furthermore, such a transaction results in the permanent disallowance of the capital loss, rather than simply a deferral to a later date as in the case of replacing the investment inside a taxable account.

How to Avoid Wash Sales

In general, wash sales are best avoided (if possible) in order to preserve the tax-benefit of the capital loss. Wash sales can be avoided by waiting until the 61-day wash sale period is over before repurchasing exactly the same investment. If an investor wishes to stay invested in a similarly-performing investment, the investor could purchase securities that are similar but not substantially identical to the investment that was sold off.

When a Wash Sale Might be Beneficial

Sometimes having a wash sale might turn out to be beneficial on a tax return. A taxpayer might find that her capital gains are going to be taxed at the zero-percent tax rate, in which case a capital loss to offset that capital gain would result in no tax savings. In this case, the taxpayer could purchase the same or substantially identical securities in an effort to defer the loss into another year in which the loss might be more valuable.