30.6 Wash Sales

The objective of the wash-sale rule is to disallow a loss deduction where you recover your market position in a security within a short period of time after the sale. Under the wash-sale rule, which applies to investors and traders (but not dealers), your loss deduction is barred if within 30 days of the sale you buy substantially identical stock or securities, or a “put” or “call” option on such securities. The wash-sale period is 61 days—running from 30 days before to 30 days after the date of sale. The end of a taxable year during this 61-day period does not affect the wash-sale rule. The loss is still denied. If you sell at a loss and your spouse buys substantially identical stock within this period, the loss is also barred.

Caution

Wash Sale Rule Applies If Replacement Bought in IRA

The IRS has ruled that a loss on the sale of stock is disallowed by the wash sale rule if within 30 days before or after the sale replacement shares are bought through a traditional IRA or Roth IRA.

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The wash-sale rule does not apply to gains. It also does not apply to acquisitions by gift, inheritance, or tax-free exchange.

Buying replacement shares through IRA.

The IRS has ruled that buying replacement shares in a traditional IRA or Roth IRA triggers the wash-sale rule. Some commentators had suggested that the wash-sale rule should not apply because the seller and the IRA, although “related,” are different entities for tax purposes. The IRS disagrees. Although the IRA is a separate tax-exempt trust, the seller of the loss shares is treated as acquiring the replacement shares through the IRA.

There is an additional penalty for using an IRA to acquire replacement shares. The increase to basis that generally applies when a loss is disallowed by the wash-sale rule does not apply here. That is, your basis in the shares held in the IRA is not increased by the disallowed loss on the original sale and the loss is permanently disallowed. In other wash sales, the basis increase preserves for future use the economic value of the disallowed loss by allowing gain to be reduced, or loss to be increased, on a later sale of the replacement shares.

Loss on the sale of part of a stock lot bought less than 30 days ago.

If you buy stock and then, within 30 days, sell some of those shares, a loss on the sale is deductible; the wash-sale disallowance rule does not apply.

Planning Reminder

Tax Advantage of Wash-Sale Rule

Sometimes the wash-sale rule can work to your advantage. Assume that during December you are negotiating a sale of real estate that will bring you a large capital gain. You want to offset a part of that gain by selling certain securities at a loss. You are unsure just when the gain transaction will go through. It may be on the last day of the year, at which point it may be too late to sell the loss securities before the end of the same year.

You can do this: Sell the loss securities during the last week of December. If the profitable deal goes through before the end of the year, you need not do anything further. If it does not, buy back the loss securities early in January. The December sale will be a wash sale and the loss disallowed. When the profitable real estate sale occurs next year, you can sell the loss securities again. This time the loss will be allowed and will offset the gain.

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Oral sale-repurchase agreement.

The wash-sale rule applies to an oral sale-repurchase agreement between business associates.

Defining “substantially identical.”

What is substantially identical stock or securities? Buying and selling General Motors stock is dealing in an identical security. Selling General Motors and buying Chrysler stock is not dealing in substantially identical securities.

Bonds of the same obligor are substantially identical if they carry the same rate of interest; that they have different issue dates and interest payment dates will not remove them from the wash-sale provisions. Different maturity dates will have no effect, unless the difference is economically significant. Where there is a long time span between the purchase date and the maturity date, a difference of several years between maturity dates may be considered insignificant. A difference of three years between maturity dates was held to be insignificant where the maturity dates of the bonds, measured from the time of purchase, were 45 and 48 years away. There was no significant difference where the maturity dates differed by less than one year, and the remaining life, measured from the time of purchase, was more than 15 years.

The wash-sale rules do not apply if you buy bonds of the same company with substantially different interest rates, buy bonds of a different company, or buy substantially identical bonds outside of the wash-sale period.

Planning Reminder

Basis Adjusted for New Stock

Although the loss deduction is barred if the wash-sale rule applies, the economic loss is not forfeited for tax purposes. The loss might be realized at a later date when the repurchased stock is sold, because after the disallowance of the loss, the cost basis of the new lot is increased by the disallowed loss. However, the basis increase is not allowed by the IRS if the shares are purchased by your IRA rather than by you individually.

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Warrants.

A warrant falls within the wash-sale rule if it is an option to buy substantially identical stock. Consequently, a loss on the sale of common stocks of a corporation is disallowed when warrants for the common stock of the same corporation are bought within the period 30 days before or after the sale. But if the timing is reversed—that is, you sell warrants at a loss and simultaneously buy common stock of the same corporation—the wash-sale rules may or may not apply depending on whether the warrants are substantially identical to the purchased stock. This is determined by comparing the relative values of the stock and warrants. The wash-sale rule will apply only if the relative values and price changes are so similar that the warrants become fully convertible securities.

Repurchasing fewer shares.

If the number of shares of stock reacquired in a wash sale is less than the amount sold, only a proportionate part of the loss is disallowed.

Holding period of new stock.

After a wash sale, the holding period of the new stock includes the holding period of the old lots. If you sold more than one old lot in wash sales, you add the holding periods of all the old lots to the holding period of the new lot. You do this even if your holding periods overlapped as you purchased another lot before you sold the first. You do not count the periods between the sale and purchase when you have no stock.

Losses on short sales.

Losses incurred on short sales are subject to the wash-sale rules. A loss on the closing of a short sale is denied if you sell the stock or enter into a second short sale within the period beginning 30 days before and ending 30 days after the closing of the short sale. Furthermore, you cannot deduct a loss on the closing of a short sale if within 30 days of the short sale you bought substantially identical stock.