Wash Sale Rule: Tax Loss Disallowance

The "wash sale" rule, codified in Internal Revenue Code Section 1091, prevents taxpayers from claiming a tax deduction for a loss on a security sale if they repurchase the same or substantially identical security within 30 days. This guide explains how the rule works and its implications for investors.

What is a Wash Sale?

A wash sale occurs when an investor sells a security at a loss and then repurchases the same or substantially identical security within a specified timeframe. The Internal Revenue Service (IRS) established this rule to prevent taxpayers from claiming a tax deduction for a loss on a sale while still maintaining an ownership interest in the security.

Key Components of the Wash Sale Rule

1. Timeframe: The wash sale rule applies to transactions that occur within a 30-day window before and after the sale of the security. This means if you sell a stock at a loss, you cannot deduct that loss for tax purposes if you buy the same or a substantially identical stock during this 30-day period.

2. Identical Securities: The term "substantially identical" refers to stocks or securities that are essentially the same in nature. This includes options and contracts to acquire stock. For instance, if you sell shares of Company A at a loss and buy back the same shares or an option to acquire them within the wash sale period, the loss will be disallowed for tax purposes.

3. Exceptions: The wash sale rule does not apply if the taxpayer is a dealer in stocks or securities and the loss occurred in the ordinary course of their business. This means that professional traders may have different rules regarding loss deductions.

How the Wash Sale Rule Works

The mechanics of Section 1091 can be broken down into several parts, each dealing with different scenarios of stock transactions.

A. Disallowance of Loss Deductions

Under Section 1091(a), if you claim a loss on the sale of stock or securities and purchase substantially identical stock within the wash sale period, you cannot deduct that loss. This affects your tax liability.

Example 1: A Simple Wash Sale Scenario

Scenario: Jane sells 100 shares of XYZ Corp for $50 per share, resulting in a loss of $1,000 since her purchase price was $60 per share. Within two weeks, Jane buys back 100 shares of XYZ Corp at $45 per share.

• What Happens: Jane cannot claim the $1,000 loss on her tax return because she repurchased the same stock within the 30-day period. Instead, the disallowed loss will be added to the basis of the repurchased stock, which adjusts her cost basis for future transactions.

B. Stock Acquired Less Than Stock Sold

If the amount of stock acquired is less than the amount sold, the IRS has specific guidelines on determining which shares are considered for the wash sale rule.

Example 2: Partial Wash Sale

Scenario: John sells 200 shares of ABC Inc. at a loss and then buys back 150 shares within the wash sale period.

• Determination: Only the loss from the 150 shares repurchased will be disallowed. The remaining shares sold (50 shares) can have their loss recognized.

C. Stock Acquired Not Less Than Stock Sold

Conversely, if the taxpayer acquires an amount equal to or greater than the amount sold, the loss on the entire transaction may be disallowed.

Example 3: Full Wash Sale

Scenario: Sarah sells 100 shares of DEF Ltd. at a loss and within two weeks, she buys 100 shares back.

• What Happens: The loss from the sale of the 100 shares is disallowed under the wash sale rule. The disallowed loss will be added to the basis of the newly acquired stock.

Adjusting the Basis of Acquired Stock

When a loss is disallowed due to a wash sale, the disallowed amount is not lost forever. Instead, it adjusts the basis of the new shares acquired. This means the cost basis of the repurchased stock will reflect the disallowed loss.

Example 4: Basis Adjustment

Scenario: If Sarah's original purchase price for the DEF Ltd. shares was $1,000 (or $10 per share), and her loss of $200 is disallowed, her new basis for the repurchased shares will be:

• Original Basis: $1,000
• Disallowed Loss: $200
• New Basis: $1,200

This adjusted basis will impact her future capital gains or losses when she eventually sells the shares again.

Short Sales and Wash Sales

In addition to standard purchases and sales, the wash sale rule also applies to short sales. Under IRC Section 1091(e), if you close a short sale and then engage in further transactions involving substantially identical securities within the wash sale window, the same principles apply.

Example 5: Short Sale Wash Sale

Scenario: Mark opens a short sale for 50 shares of GHI Corp and closes it at a profit. However, he then buys shares of GHI Corp within the wash sale period.

• Tax Implications: If Mark sells the shares at a loss shortly after buying them back, the loss will be disallowed under the wash sale rule, just as it would be with any other stock purchase.

Cash Settlements and Wash Sales

The wash sale rule also encompasses contracts or options that settle in cash or property other than stock or securities. This means that even if your transaction does not involve physical stock transfers, the wash sale rule may still apply.

Example 6: Cash Settlement

Scenario: Lisa has an options contract to buy shares of JKL Co. She sells the option at a loss and then buys back a substantially identical option within the 30-day window.

• What Happens: The loss from the option sale would be disallowed, similar to an actual stock sale, because the wash sale rule applies regardless of whether the settlement involves cash or other forms of property.

Practical Guidance

1. Track Your Transactions: Keep records of all trades, including dates, amounts, and prices to identify wash sales.

2. Plan Your Sales: If selling a security at a loss for tax purposes, wait more than 30 days before repurchasing the same or substantially identical security.

3. Consider Tax Implications: Active traders should be aware that frequent buying and selling of the same stocks can create multiple wash sales, complicating tax reporting.

4. Use Tax Software: Tax preparation programs can identify potential wash sales and ensure accurate reporting.

5. Consult a Tax Professional: If you frequently trade, consider consulting a tax professional familiar with securities transactions.

Conclusion

The wash sale rule under Section 1091 disallows loss deductions when you repurchase substantially identical securities within 30 days. Understanding how losses are disallowed and how basis adjustments work helps investors plan trading strategies and manage tax obligations. Keep accurate records and consider transaction timing to avoid unexpected tax consequences.