Tax Time: Down and Dirty with the Wash Sale Rule

It’s coming down to the wire for traders to finish their taxes. Did the wash sale rule trip you up again this year? You’re not alone.

The wash sale rule has been confusing traders for a long time. Let’s clear up some of the confusion and look at a couple ways traders can avoid a wash sale.

First, let’s define a wash sale.

Suppose a trader sells XYZ at a loss. If he buys XYZ, or a security related to XYZ, 30 days before or after the day of the sale, the loss is disallowed by the Internal Revenue Service (IRS). Thus, the sale of XYZ and the separate purchase of XYZ (or a substantially identical security) is called a wash sale.

Importantly, the wash sale rule doesn’t prevent the trader from claiming a loss on XYZ. Instead, the loss is deferred until the repurchased shares of XYZ are sold. Then adjustments are made to the cost basis and holding period of the repurchased shares.

Wash Sale Walk-Through

Is it any wonder traders get confused by this rule? Let’s walk through a trade example to help clear things up. Suppose that:

• On Thursday, a trader buys 100 shares of FAHN at $50.
• On Friday, FAHN drops to $45 and he sells 100 shares.
• He records a loss of $5 per share.
• The following Monday, he repurchases 100 shares of FAHN at $48.
• He holds FAHN for 90 days before selling his shares for a profit.
• The repurchased shares at $48 need to account for the disallowed loss from the first sale.
• The loss from the first sale was $5 per share.
• This loss is added to the cost basis of the repurchased shares at $48.
• The resulting cost basis is $53 per share.
• Finally, the holding period of one day is added to the holding period of the repurchased shares for a total of 91 days.

So you aren’t surprised by a wash sale being triggered?

Now that you have a better understanding of the wash sale rule, what can you do to avoid triggering it? One approach is known as the double-down strategy. Some traders might use it to recognize a large loss for tax purposes while still holding on to the same stock. It works like this:

• Suppose a trader buys 100 shares of XYZ at $100 in June.
• By November, XYZ drops to $60. The trader has a $40 unrealized loss.
• For tax purposes, he wants to recognize the loss, but still hold on to XYZ because he thinks it’ll rebound.

The trader can buy another 100 shares of XYZ at $60, wait for 31 days to avoid a wash sale, then sell the first 100 shares purchased at $100 back in June. This lets him recognize the loss and still hold on to XYZ.

But—and this is a big one—doubling the position size in a stock increases risk. This can be particularly risky if the stock already accounts for a large portion of a portfolio. If the stock continues dropping, it could result in bigger losses since the position size is now doubled.

Another strategy traders might use to recognize a loss for tax purposes, avoid the wash sale rule, and still maintain a position in the market is to replace one stock with another. It works like this:

• Suppose a trader has a loss in a large-cap technology stock.
• She could sell tech stock A to recognize the loss.
• She could turn around and buy large-cap tech stock B that’s in the same sector.
• After 31 days, she could sell tech stock B and buy back tech stock A.

The idea behind the replacement strategy is to maintain exposure to a similar stock while waiting out the 31 days for the wash sale rule to expire. This is acceptable from a tax perspective, but it’s risky from an investing perspective. Tech stock B could go down while the trader is waiting out those 31 days.

When it comes to recognizing a loss for tax purposes while trying to avoid the wash sale rule and simultaneously staying invested, it’s clear there isn’t a clean solution. Weigh the benefits of recognizing the loss against the potential risks of staying invested. If you need help with this analysis, be sure to take advantage of the resources below.