Beware of the wash sales rule!

When you lose money due to the value of the stock going down, you may try to get rid of that stock.  There is nothing wrong in that.  You plan to claim this loss on your tax return. However, when you realize that the stock is bouncing back, you may buy it again.  And here you’re stuck with the wash sale rule.  If you try to get replacement of the stock sold, and that too within a very short time, IRS does not allow you to claim the loss on the previous transaction.

Example – On January 10, you sell 100 shares in ABC at a loss.  And then on February 2, you buy 100 shares of ABC again.  In this case, the sale you made on January 10 is called a ‘wash sale’.

The wash sale rule applies to you even though you did not acquire the stock.  Suppose you enter into a contract to buy stock, then also the wash sale rule applies.

The effects of wash sale:

1. You cannot claim the loss on your sale transaction due to wash sale rule.

2. This loss can be added to the basis of the stock newly purchased by you.  So the benefit of claiming loss is kept intact.  You will receive the benefit when you sell the replacement stock.  Let us take an example to explain this.  You bought hundred shares of ABC at $50.  The stock has gone down to $30 and you sell it off in order to claim the loss on your return.  Soon, you realize some good news about the stock and you buy it again at $32 within 30 days after the sale.

In this situation the initial loss you made of $20 per share will not be deductible on your tax return.  Instead you can add this loss as a basis to your newly acquired stock.  So the newly acquired stock is assumed to have a purchase price of $52 and when you sell it, say for $55, you need to report a profit of only $3.

So this allowance is not a disaster.  It is only postponing your tax benefit for some time.  You can take the benefit later, perhaps in the same year.

However, if you die before selling the newly acquired replacement stock, you or your heirs will not be benefited for the transaction.  Also, if you dispose the stock to a related person, or to your IRA, you lose the entire benefit.

3. When you make such a wash sale, the period of holding the replacement stock will be added with the period for which you held the original stock.  So you cannot convert a long term loss into a short term one!  So if you make the wash sale of the stock you held for years and you sell the replacement stock within months, your loss will be a long term loss.

There are some finer points you need to understand about the wash sale rule.  The rule applies to exactly identical stock.  It does not apply to ‘similar’ stock.  Also, the rule applies only to losses.  So if you make a gain out of such transaction, this rule is not applicable and you have to pay taxes on your gain.  So it is a win-win situation for IRS!

What about mutual fund shares?  The rule applies to sales of mutual fund shares also.  IRS has already plugged this loophole by making a rule that all the circumstances have to be considered in making a decision about whether a stock or security is substantially identical or not.  And never think of buying your replacement stock in the name of your spouse.  You’re still not allowed to claim the loss.

How to avoid this rule?  Try to plan your sale keeping a minimum gap.  If you are really convinced about the bouncing back of the stock, then        just go ahead and buy it.  You will cover your loss against your gain in the future anyway!