When a taxpayer sells stocks or securities held for investment at a loss, that individual may be able to take that capital loss as a deduction against their capital gains. However, if the taxpayer engages in a wash sale transaction, then any losses that result from it may not be deducted.
What Is a Wash Sale?
A wash sale occurs in two steps. First, the transaction requires a taxpayer to sell stocks or securities at a loss. Next, within 30 days before or after the date of the sale that resulted in a loss, the taxpayer acquires or agrees to acquire "substantially identical" stocks or securities to the ones sold. Put simply, a wash sale is essentially swapping an investment for another investment. The government is not inclined to offer deductions for this type of transaction in order to discourage individuals from staging artificial losses in order to receive tax benefits.
If the taxpayer’s sale results in a loss, then that loss will be disallowed. For example:
T purchases 20 shares of ABC Inc. 5 days after he sold 20 shares of ABC Inc. at a loss of $50. That $50 will not be allowed as a deduction for T.
Complications arise when the number of stocks acquired by the taxpayer does not match the number of stocks sold. The tax treatment in those cases depends on whether more or lesser number of stocks is purchased.
Does the Wash Sale Rule Apply to Sales That Result in a Gain?
No. The wash sale rule only disallows the deduction of losses. Any gain that results from a wash sale will normally be taken into account as income. The amount of an individual’s tax liability on gains will depend on several factors, such as the gains were long term or short term, and the type of sale, specifically whether the sale was for a capital asset or a personal residence.
What Will Happen to the Disallowed Loss?
If the taxpayer is not able to claim the loss, that loss will not be lost forever. When losses are disallowed from a wash sale, they are added to the cost basis of the newly acquired "substantially identical" stocks or securities. For example:
In the previous example, T has purchased the 20 shares of ABC Inc. for $50. The cost basis of these stocks would be $100 ($50 cost + $50 disallowed loss).
What Is Considered “Substantially Identical”?
The definition of "substantially identical" depends on the facts and circumstances of a particular case, and it will mean different things in different situations. Generally, stocks from one company are not considered "substantially" identical to another company, even though they may be the same size and in the same industry. Furthermore, bonds and preferred stocks are also usually not "substantially identical" to common stocks, even if the stock is from the same company.
Is the Holding Period of the Stock Sold at a Loss in a Wash Sale Tacked onto Newly Acquired Stocks?
Yes. The period you held the stocks sold at a loss in a wash sale will be added to the newly acquired stocks. Adding to the previous example:
T had held the 20 ABC Inc. stocks that he sold for 3 years at the time of the sale. Because T purchased the new stock 5 days after the sale, T’s holding period for those new 20 shares of ABC Inc. would be 3 years and 5 days, thereby given T long-term capital treatment.
Do I Need an Attorney to Advise Me on Tax Issues?
Tax laws are complex and ever-changing. Although there are computer programs on the market that may help you with your tax problems, they cannot provide the same level of service that an experienced and knowledgeable tax attorney can. If you are unsure about the characterization of your losses or you need someone to represent you before the IRS, you should consider consulting with a local tax lawyer.