A wash sale (not to be confused with a wash trade) is a sale of a security (stock, bonds, options) at a loss and repurchase of the same or substantially identical security shortly before or after. The regulations around wash sales are to protect against an investor who holds an unrealized loss and wishes to make it claimable as a tax deduction within the current tax year. The security is then repurchased in the hope that it will recover its previous value, which would only become taxable in some future tax year. A wash sale can take place at any time during the year. In the UK, a similar practice which specifically takes place at the end of a calendar year is known as bed and breakfasting. In a bed-and-breakfasting transaction, a position is sold on the last trading day of the year (typically late in the trading session) to establish a tax loss. The same position is then repurchased early on the first session of the new trading year, to restore the position (albeit at a lower cost basis). The term, therefore, derives its name from the late sale and early morning repurchase.
In some tax codes, such as the USA and the UK, tax rules have been introduced to disallow the practice (e.g. if the stock is repurchased within 30 days of its sale). The disallowed loss is added to the basis of the newly acquired security.
- Buys substantially identical stock or securities,
- Acquires substantially identical stock or securities in a fully taxable trade,
- Acquires a contract or option to buy substantially identical stock or securities, or
- Acquires substantially identical stock for an individual retirement account (IRA).
The "substantially identical stock" acquired in any of these ways is called the "replacement stock" for that original position.
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In USA, the wash sale rule has the following consequences:
- The taxpayer is not allowed to claim the loss on the sale (the loss is not "realized").
- Basis Adjustment: The disallowed loss is added to the cost basis of the replacement stock.
- Holding Period: The holding period for the replacement stock includes the holding period of the stock you sold.
After a sale is identified as a wash sale and if the replacement stock is bought within 30 days before or after the sale then the wash sale loss is added to the basis of the replacement stock. The basis adjustment is important as it preserves the benefit of the disallowed loss; the holder receives that benefit on a future sale of the replacement stock.
Note: The identification of a wash sale and adjusting the basis of the replacement stock is an iterative process. Thus, the sale of the replacement stock (after its basis is adjusted) can also be identified as a wash sale if it meets the above criteria.
Example: Some time ago you bought 80 shares of XYZ at $50. The stock has declined to $30, and you sell it to take the loss deduction. But then you see some good news on XYZ and buy it back for $32, less than 31 days after the sale. You can't deduct your loss of $20 per share. But you add $20 per share to the basis of your replacement shares. Those shares have a basis of $52 per share: the $32 you paid, plus the $20 wash sale adjustment. In other words, you're treated as if you bought the shares for $52. If you end up selling them for $55, you'll only report $3 per share of gain. And if you sell them for $32 (the same price you paid to buy them), you'll report a loss of $20 per share.
Because of this basis adjustment, the wash sale rule usually does not have a significant impact. In most cases, it simply means you'll get the same tax benefit at a later time. If you receive the benefit later in the same year, the wash sale may have no effect at all on your taxes.
There are times, though, when the wash sale rule can have undesirable consequences.
- If you don't sell the replacement stock in the same year, your basis adjustment benefits will be postponed, possibly to a year when the deduction is of far less value.
- If you die before selling the replacement stock, neither you nor your heirs will benefit from the basis adjustment.
- You can also lose the benefit of the deduction permanently if you sell stock and arrange to have a related person—or your IRA—buy replacement stock.
When a wash sale occurs, the holding period for the replacement stock includes the period you held the stock you sold.
Example: You've held shares of XYZ for 10 years. You sell it at a loss but then buy it back within the wash sale period. When you sell the replacement stock, your gain or loss will be long-term—no matter how soon you sell it.
Unintended wash sales
Suppose you redeem 50 shares from your mutual fund account by writing a check. If the price received for the shares is lower than your average cost, you realize a loss. Suppose further that later that month the fund reinvests a dividend distribution into your account, purchasing 5 new shares. Because of this wash sale (even though it was inadvertent), the loss attributable to an amount equal to the distribution would be disallowed.
- "Internal Revenue Code Sec. 1091".
- "CFR 1.1091-1". Retrieved 1 April 2015.
- "CFR 1.1091-2". Retrieved 1 April 2015.
- "Investment Income and Expenses" (PDF). IRS Publication 550. 2011. p. 60. Retrieved 14 Sep 2012.
- Thomas, Kaye A. (April 8, 2011). "Wash Sales 101". Tax Guide for Investors. Fairmark Press Inc. Retrieved 14 Sep 2012.