Wash-Sale Rule

Wash-Sale Rule — Definition and Purpose

A wash sale occurs when an investor sells a security at a loss and buys the same or a “substantially identical” security within 30 days before or 30 days after the sale. The rule—enforced by the IRS—prevents taxpayers from realizing a tax loss while essentially retaining the same investment position.

Key purpose:
* Stop investors from claiming a deductible capital loss when they re-enter a similar position immediately.
* Ensure tax losses are only recognized when the investor genuinely changes their economic position.

Key Takeaways

• A wash sale is triggered by buying a substantially identical security within 30 days before or after a loss sale.
• Losses disallowed by the wash-sale rule cannot be claimed in that tax year but are deferred by adjusting the cost basis of the replacement security.
• The rule applies to stocks, contracts, options, and other securities, and can affect trades between taxable accounts and IRAs.

How the Rule Works

1. You sell a security for a loss.
2. You purchase the same or a substantially identical security within the 30-day window before or after the sale.
3. The loss is disallowed for current tax deduction purposes but is added to the cost basis of the new shares, deferring the tax benefit until those shares are sold.

Note: The “window” is commonly described as 30 days before and 30 days after the sale (often noted together as a 61-day span including the sale date).

Example

You have a $15,000 gain from one stock sale and a $7,000 loss from another. If the $7,000 loss is valid, your net taxable gain is $8,000. If you repurchase the losing position within the wash-sale window, the $7,000 loss is disallowed for that tax year and instead increases the basis of the newly bought shares.

Reporting and Tax Treatment

• Disallowed loss is added to the cost basis of the replacement shares. That deferred loss reduces future taxable gains when the replacement shares are sold.
• The holding period of the sold shares carries over to the replacement shares, which can affect short-term vs. long-term gain classification.
• Brokers report wash sales on Form 1099-B when information is available, but taxpayers remain responsible for accurate reporting.

Special Considerations

• Substantially identical: Common stock vs. options, convertible preferred stock, or certain fractional and derivative positions may be considered substantially identical depending on terms. Bonds and preferred stock are generally not treated as substantially identical to common stock unless conversion or rights make them equivalent.
• IRAs: Purchases in an IRA can trigger wash-sale consequences for sales in taxable accounts. Per IRS guidance, a loss sold in a taxable account is disallowed if substantially identical shares are bought in an IRA within the 30-day window; the loss is lost (basis in IRA is not adjusted).
• Day traders: Frequent trading increases the risk of triggering wash sales. Tax treatment can be complex—consider consulting a tax professional.
• Options and contracts: Buying or writing options that recreate the same economic exposure can trigger the rule.

Practical Tips to Avoid Triggering Wash Sales

• Wait at least 31 days before repurchasing the same security.
• Replace a sold holding with a similar—but not substantially identical—security (e.g., different ETF covering the same sector, or an ETF vs. individual stock).
• Use tax-loss-harvesting alternatives: pick a passive ETF in the same asset class with different holdings or a similar mutual fund that isn’t substantially identical.
• Track trades across all accounts (including IRAs and family accounts where applicable) to avoid inadvertent wash sales.
• When in doubt, consult a tax advisor—especially for complex situations (large portfolios, derivatives, IRA interactions).

Quick FAQ

• Is a wash sale illegal? No—trading that triggers a wash sale is legal; the issue is the tax disallowance of the loss.
• How long is the wash-sale period? It covers purchases 30 days before or 30 days after the loss sale (commonly referenced together as a 31‑day before/after span around the sale).
• Will a disallowed loss disappear? Not permanently—it’s added to the basis of the replacement shares and can reduce future taxable gain.

Bottom Line

The wash-sale rule prevents immediate tax recognition of capital losses when investors repurchase substantially identical securities in a short window around the sale. While losses disallowed under the rule are not lost forever, they are deferred through an adjustment to the replacement security’s basis. Awareness of the rule and careful trade planning are essential for effective tax-loss harvesting and overall tax planning.

Sources

• IRS Publication 550, Investment Income and Expenses
• IRS Topic No. 409, Capital Gains and Losses
• Rev. Rul. 2008-5 (wash-sales and IRAs)
• HM Revenue & Customs, “Bed and Breakfasting” (U.K. guidance)