Stock Wash Rule: How to Determine Similar Stock for Tax Purposes
Learn how to navigate the wash sale rule by understanding what qualifies as substantially identical stock, timing rules, cost basis adjustments, and documentation.
Selling a stock at a loss and quickly repurchasing it might seem like a straightforward way to claim a tax deduction. However, the IRS employs the “wash sale rule” to prevent investors from generating artificial losses solely for tax benefits without genuinely altering their investment position. Failing to adhere to this rule can lead to the disallowance or deferral of your loss deduction.
A particularly challenging aspect of this rule involves determining when a repurchased security is considered “substantially identical” to the one sold at a loss. This article explores how that determination is made for tax purposes.
Key Factors in Determining Similar Stock
Identifying whether a replacement security is “substantially identical” to one sold at a loss is central to applying the wash sale rule, referenced in the Internal Revenue Code.1Legal Information Institute. 26 U.S. Code § 1091 – Loss From Wash Sales of Stock or Securities This assessment prevents taxpayers from claiming losses when their investment position remains essentially unchanged. The Internal Revenue Service (IRS) avoids a strict definition, instead evaluating the unique facts and circumstances of each situation.
While no rigid formula exists, IRS guidance indicates that stocks or securities of different corporations are generally not considered substantially identical. Selling shares in Company A at a loss and buying shares in Company B, even within the same industry, usually bypasses the wash sale rule concerning identical securities. An exception might occur during corporate reorganizations, where stock in a successor company could be deemed substantially identical to that of its predecessor.
Within the same corporation, different classes of securities are typically distinct. Common stock and preferred stock of the same issuer, for example, are usually not substantially identical due to differing rights and features. Similarly, corporate bonds are generally distinct from the corporation’s common stock. However, convertible securities require closer examination; preferred stock or bonds convertible into common stock may be considered substantially identical if their values, price movements, and conversion terms closely align them with the common stock.
The rule also encompasses contracts or options to acquire or sell stock. Purchasing a call option on the same stock recently sold at a loss is treated similarly to repurchasing the stock itself. The evaluation consistently focuses on whether the replacement security mirrors the fundamental characteristics and economic position of the security sold.
Wash Rule Timeframe
Timing is fundamental to the wash sale rule. The regulation establishes a specific period around the date of a sale that results in a loss. Acquiring substantially identical securities within this timeframe triggers the rule, disallowing the loss deduction for that tax year.
This period covers 61 days: the 30 calendar days before the sale, the date of the sale, and the 30 calendar days after the sale. For instance, selling stock at a loss on July 15th means the restricted period runs from June 15th through August 14th. Purchasing substantially identical securities, or entering a contract or option to do so, anytime within this 61-day window activates the wash sale rule for the associated loss.
Adjusting Cost Basis
When a wash sale occurs, the immediate tax deduction for the loss is disallowed. However, the economic impact of the loss is deferred, not permanently lost. The tax code allows for an adjustment to the cost basis of the replacement securities.
This adjustment involves adding the disallowed loss amount to the purchase price of the newly acquired, substantially identical securities.2Internal Revenue Service. Publication 550, Investment Income and Expenses For example, if you buy 100 shares for $1,500, sell them for $1,000 (a $500 loss), and then buy 100 identical shares for $1,100 within 30 days, the $500 loss is disallowed initially. This $500 is added to the $1,100 cost of the new shares, making their adjusted cost basis $1,600.
This adjusted basis affects the gain or loss calculation when the replacement shares are eventually sold. Selling the replacement shares (with the $1,600 adjusted basis) for $1,800 results in a $200 taxable gain ($1,800 – $1,600). If sold for $1,400, the deductible loss would be $200 ($1,400 – $1,600). The disallowed loss is thus factored into the subsequent transaction’s outcome.
Additionally, the holding period of the original shares sold at a loss is added to the holding period of the replacement shares. This “tacking” determines whether a future gain or loss is short-term or long-term. If the original shares were held long-term, that period carries over, potentially qualifying gains on the replacement shares for lower long-term capital gains rates, even if the replacement shares themselves were held briefly.
Recordkeeping Essentials
Maintaining accurate records is necessary when managing stock transactions, particularly concerning the wash sale rule. Proper documentation is needed to demonstrate compliance, track purchases of potentially substantially identical securities within the 61-day window, and correctly adjust basis when required.
Effective recordkeeping involves logging key details for every transaction:
- Date of purchase/sale
- Number of shares or units
- Exact name of the security (ticker/CUSIP)
- Total purchase price (including commissions)
- Total sale proceeds (net of expenses)
This information allows you to identify losses and check for corresponding purchases within the restricted timeframe.
While brokerage firms issue Form 1099-B reporting sales proceeds and sometimes wash sale adjustments for identical securities in the same account, this may not capture the full picture.3Internal Revenue Service. Instructions for Form 1099-B Taxpayers are responsible for tracking wash sales involving substantially identical securities across all accounts, including those at different firms, IRAs, and potentially a spouse’s accounts if filing jointly. Brokers typically do not track these broader scenarios, making personal records essential for full compliance.
Comprehensive records serve as proof for your reported capital gains and losses if questioned by the IRS. They substantiate disallowed losses and corresponding basis adjustments. IRS Publication 550, “Investment Income and Expenses,” advises keeping records related to asset basis until the statute of limitations expires for the year the asset is sold, which often means holding purchase records long-term. Organized records simplify tax preparation and provide necessary backup.4Internal Revenue Service. Managing Your Tax Records After You Have Filed