Let’s say you own stock that you bought years ago for $5,000 but is now worth only $2,000. You believe that the stock will eventually increase in value; however, you would like to recognize the $3,000 loss. You sell the stock, recognize the $3,000 loss, and then immediately buy the same stock at $2,000. You are in the same position you were before the sale, but you now have a $3,000 tax loss.
Unfortunately, Congress didn’t like the above transaction so it created the wash loss rules. Under these rules, taxpayers cannot deduct the loss realized on the sale of stock or securities (including shares in a mutual fund) if taxpayers purchase substantially identical stock or securities within the period beginning 30 days before and ending 30 days after the sale.
For the wash sale rules to apply, the stocks or securities must be substantially identical. Ordinarily, stocks or securities of one corporation are not substantially identical to stocks and securities of another corporation. For example, you could sell stock of Microsoft at a loss and purchase shares of Google within 30 days and still claim the loss on Microsoft stock.
A loss that is not recognized under the wash loss rules is not permanently banned; it is deferred and can be recognized on a future sale. This is done by increasing the basis of the substantially identical stock or securities. The holding period (which determines whether the sale generates long term or short term capital gain) of the substantially identical stock or securities includes the holding period of the original stock or securities sold.
Example: In the fact scenario above, the $3,000 will be disallowed because identical stock was purchased within 30 days of the sale of the original stock (in the above scenario, the identical stock was purchased immediately after the original stock was sold). The disallowed loss of $3,000 is added to the basis of the identical stock cost of $2,000 for a basis in the new stock of $5,000. The long term holding period of the original stock is now applied to the identical stock.
A wash sale can be used to generate long term capital gain if the stock increases in value after the original shares are sold.
Example: In 2004 Toby purchased stock for $8,000. In 2012, the stock is worth $7,000. Toby sells the stock for a $1,000 loss. Two weeks after Toby sold the stock, it continued to decline in value and is now worth $5,000. Toby believes the stock is undervalued and buys it for $5,000. Since Toby purchased identical stock within 30 days of the original sale, the $1,000 loss is disallowed. The disallowed loss of $1,000 is added to the purchase price of the identical shares of $5,000 for a total basis of $6,000. Now assume the stock skyrockets in value two months later. If Toby sells the identical stock for $8,000 he would have a long term capital gain of $2,000. The gain is long term even though Toby only held the new stock for two months because the holding period of the original stock applied to the later purchase of the identical stock.
The wash sale rules can cause trouble when an investor disposes of several blocks of stock and at the same time and some blocks were sold at gains and the rest were sold at losses. Wash sale rules only apply to losses. The gains will be recognized, but the losses will be disallowed (i.e., the gains and losses cannot be netted against each other).
The fact that wash sale rules do not apply to gains can be used to your advantage. Capital losses are deductible against capital gains and against $3,000 of ordinary income each year. If you have a large capital loss and no capital gains, it may take a while to fully deduct that large capital loss when you can only use it to offset $3,000 of ordinary income per year. The following strategy can help:
Example: John has a $60,000 capital loss carryover. It would take him 20 years to fully deduct this loss if he has no capital gains. John also owns shares of Apple that he purchased in the 1990s at $30 per share and the shares are now worth $600 per share. John could sell 105 shares at $600/share for $63,000. His basis in those shares is $3,150. His capital gain is therefore $59,850. John immediately repurchases the 105 shares of Apple at 105 for $63,000.
Up to $59,850 of the capital loss carryforward will offset John’s capital gain, and because of the repurchase, John will still own the same amount of Apple stock. John can offset the remaining $150 capital loss against his ordinary income. Additionally, John’s basis in the new Apple shares is based on the purchase price of $105 rather than the pre-sale basis of $30. The wash sale rules will not block this transaction because the Apple shares were sold at a gain.
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Buzzkill Disclaimer: This post contains general tax information that may or may not apply in your specific tax situation. Please consult a tax professional before relying on any information contained in this post.
Any tax advice contained in the body of this post was not intended or written to be used, and cannot be used, by the recipient for the purpose of avoiding penalties that may be imposed under the Internal Revenue Code or applicable state or local tax law provisions. Any information contained in this post does not fall under the guidelines of IRS Circular 230