Wash Sale

Wash Sale: Definition, How It Works, and Tax Implications

What is a wash sale?

A wash sale occurs when an investor sells a security at a loss and purchases the same or a substantially identical security within 30 days before or 30 days after the sale. The Internal Revenue Service (IRS) disallows the immediate deduction of that loss for tax purposes to prevent short-term trades intended solely to create deductible losses.

Why the rule exists

The rule prevents taxpayers from realizing a tax loss while effectively retaining the same investment position. Without it, investors could repeatedly sell losing positions, claim losses to offset gains or ordinary income, then immediately reenter the same positions.

How it works

Typical sequence:
* Sell a security at a loss and intend to claim the capital loss on your tax return.
* Repurchase the same or a substantially identical security within the restricted window.
* The loss from the sale is disallowed for current tax reporting.

Key points:
* The restricted period is 30 days before to 30 days after the sale — a 61-day span including the sale date.
* “Substantially identical” is fact-specific; the IRS evaluates based on economic equivalence (same issuer common stock vs. convertible preferred stock, for example).
* The rule applies to stocks, options, contracts, and other securities.

Example

You have a $15,000 gain on one stock and a $7,000 loss on another. Normally the $7,000 loss offsets part of the gain, reducing taxable gain to $8,000. If you repurchase the loss-position stock within the wash-sale window, the $7,000 loss is disallowed for the current year.

Tax treatment and reporting

If a loss is disallowed under the wash sale rule:
* The loss is added to the cost basis of the newly purchased substantially identical security.
* The disallowed loss is effectively deferred — it reduces taxable gain (or increases loss) when the replacement security is eventually sold in a non-wash-sale transaction.
* The holding period of the sold shares is tacked onto the holding period of the replacement shares for determining long-term vs. short-term status.

Special considerations

• IRA purchases: Buying substantially identical securities in an IRA within the wash-sale window can trigger the rule. Per Rev. Rul. 2008-5, the disallowed loss is neither deductible nor added to the IRA basis.
• Day traders: Frequent trading increases the risk of wash sales. Tax reporting for active traders is complex; consult a tax professional.
• Bonds and preferred stock: These are not automatically considered substantially identical to common stock of the same issuer, but specific features (e.g., unrestricted convertibility) can change that analysis.
• Options and derivatives: The rule applies broadly to contracts and options that are substantially identical economically.

How to avoid triggering a wash sale

• Wait 31 days after the sale before repurchasing the same security.
• Replace with a similar, but not substantially identical, security (e.g., different ETF that tracks the same index but has different holdings).
• Use tax-efficient rebalancing strategies or consult a tax advisor for alternatives that preserve market exposure without triggering the rule.

Practical tips

• Track trades across taxable and retirement accounts — purchases in an IRA or spouse’s accounts can create wash-sale issues.
• Be cautious when harvesting tax losses near year-end; the 30-day rule applies across the year boundary.
• Keep detailed records; disallowed losses must be tracked and applied to the basis of replacement securities.

Bottom line

The wash sale rule prevents taxpayers from claiming current tax losses if they repurchase substantially identical securities within a short window around the sale. Disallowed losses are not permanently lost but are deferred by adjusting the basis of replacement securities. Understanding the rule and planning around it is important for effective tax-loss harvesting and accurate tax reporting. Consult a tax professional if you trade frequently or if complex account structures (IRAs, trusts, spouse’s accounts) are involved.

Sources

• IRS Publication 550, Investment Income and Expenses
• IRS Topic No. 409, Capital Gains and Losses
• Rev. Rul. 2008-5
• HM Revenue & Customs, Capital Gains Manual: CG13350 (bed-and-breakfast rules)